Notes to Consolidated Financial Statements
June 30, 2005 and December 31, 2004
(Unaudited)
GENERAL - COMPANY
Capital Corp of the West (the “Company” or “Capital Corp”) is a bank holding company incorporated under the laws of the State of California on April 26, 1995. On November 1, 1995, the Company became registered as a bank holding company, and is a holder of all of the capital stock of County Bank (the “Bank”). During 1998, the Company formed Capital West Group, a subsidiary that engages in the financial institution advisory business but is currently inactive. The Company's primary asset is the Bank and the Bank is the Company's primary source of income. The Company’s securities consist of 54,000,000 shares of common stock, no par value, and 10,000,000 shares of authorized preferred stock. As of June 30, 2005 there were 10,490,566 common shares outstanding, held of record by approximately 1,700 shareholders. There were no preferred shares outstanding. The Bank has three wholly owned subsidiaries, Merced Area Investment & Development, Inc. ("MAID"), County Asset Advisors ("CAA"), and County Investment Trust (“REIT”). CAA is currently inactive. The Company also has two unconsolidated trusts, County Statutory Trust and County Statutory Trust II (the “Trusts”). In the second quarter of 2002, the Company purchased Regency Investment Advisors, Inc (“RIA”). RIA was sold in October 2004. The Company has one wholly owned subsidiary, Capital West Group, Inc. (“CWG”). CWG is currently inactive. All references herein to the "Company" include the Company, the Company’s subsidiaries, the Bank and the Bank's subsidiaries, unless the context otherwise requires.
GENERAL - BANK
The Bank was organized on August 1, 1977, as County Bank of Merced, a California state banking corporation. The Bank commenced operations on December 22, 1977. In November 1992, the Bank changed its legal name to County Bank. The Bank’s securities consist of one class of Common Stock, no par value which is wholly owned by the Company. The Bank’s deposits are insured under the Federal Deposit Insurance Act by the Federal Deposit Insurance Corporation (“FDIC”) up to applicable limits stated therein. Like most state-chartered banks of its size in California, it is not a member of the Federal Reserve System.
INDUSTRY AND MARKET AREA
The Bank engages in general commercial banking business primarily in Fresno, Madera, Mariposa, Merced, San Francisco, San Joaquin, Stanislaus and Tuolomne counties. The Bank has twenty full service branch offices; two of which are located in Merced with the branch located in downtown Merced currently serving as both a branch and as administrative headquarters. There are offices in Atwater, Dos Palos, Hilmar, Livingston, Los Banos, Madera, Mariposa, San Francisco, Sonora, Stockton, two offices in Modesto, four in Fresno and two offices in Turlock. The Bank’s administrative headquarters also provides accommodations for the activities of MAID, the Bank's wholly owned real estate subsidiary.
OTHER FINANCIAL NOTES
All adjustments which in the opinion of Management are necessary for a fair presentation of the Company’s financial position at June 30, 2005 and December 31, 2004 and the results of operations for the three and six month periods ended June 30, 2005 and 2004, and the statements of cash flows for the six months ended June 30, 2005 and 2004 have been included. The interim results for the three and six months ended June 30, 2005 are not necessarily indicative of results to be expected for the full year. These financial statements should be read in conjunction with the financial statements and the notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.
The accompanying unaudited financial statements have been prepared on a basis consistent with generally accepted accounting principles and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.
Basic earnings per share (EPS) is computed by dividing net income available to shareholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed by dividing net income available to common shareholders by the weighted average number of common shares outstanding during the period plus potential common shares outstanding. Diluted earnings per share 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 Company. Earnings per share data is adjusted for the effect of the nine for five stock split announced on March 29, 2005 with a distribution date of April 29, 2005.
The following table provides a reconciliation of the numerator and denominator of the basic and diluted earnings per share computation of the three month periods ended June 30, 2005 and 2004:
| | | For The Three Months | | For The Six Months | |
| | | Ended June 30, | | Ended June 30, | |
| (Dollars in thousands, except per share data) | | 2005 | | 2004 | | 2005 | | 2004 | |
| Basic EPS computation: | | | | | | | | | |
| Net income | | $ | 5,126 | | $ | 3,880 | | $ | 10,114 | | $ | 7,524 | |
| Average common shares outstanding | | | 10,479 | | | 10,283 | | | 10,479 | | | 10,247 | |
| Basic EPS | | $ | 0.49 | | $ | 0.38 | | $ | 0.97 | | $ | 0.73 | |
| | | | | | | | | | | | | | |
| Diluted EPS Computations: | | | | | | | | | | | | | |
| Net income | | $ | 5,126 | | $ | 3,880 | | $ | 10,114 | | $ | 7,524 | |
| Average common shares outstanding | | | 10,479 | | | 10,283 | | | 10,466 | | | 10,247 | |
| Effect of stock options | | | 323 | | | 351 | | | 330 | | | 372 | |
| | | | 10,802 | | | 10,634 | | | 10,796 | | | 10,619 | |
| Diluted EPS | | $ | 0.47 | | $ | 0.36 | | $ | 0.94 | | $ | 0.71 | |
INTANGIBLE ASSETS
The Company has intangible assets consisting of core deposit premiums and goodwill. Core deposit premiums are amortized using an accelerated method over a period of ten years. Intangible assets related to goodwill have not been amortized after December 31, 2001 but are reviewed periodically for potential impairment. During the second quarter of 2005, management determined there had been no impairment of goodwill. As of June 30, 2005 and December 31, 2004, the Company had unamortized core deposit premiums of $46,000 and $69,000, respectively. Amortization of core deposit premiums and other intangibles was $23,000 and $333,000 six months ended June 30, 2005 and 2004, respectively. Core deposit premiums of $460,000 and $4,340,000 were initially recorded as a result of purchasing deposits from Town and Country Finance and Thrift in July, 1996 and the purchase of three branches from Bank of America in December, 1997, respectively.
BORROWED FUNDS
During the six months ended June 30, 2005, the Bank increased its short term borrowings. The borrowings were obtained from the Federal Home Loan Bank, Pacific Coast Bankers’ Bank, and Fed Funds purchased. The increase in borrowings totaled $10,645,000 between December 31, 2004 and June 30, 2005.
STOCK COMPENSATION
The Company provides stock-based compensation to certain officers and directors. The Company uses the intrinsic value method to account for its stock option plans (in accordance with the provisions of Accounting Principles Board Opinion No. 25). Under this method, compensation expense is recognized for awards of options to purchase shares of common stock to employees under compensatory plans only if the fair market value of the stock at the option grant date (or other measurement date, if later) is greater than the amount the employee must pay to acquire the stock. Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123) permits companies to continue using the intrinsic value method or to adopt a fair value based model to account for stock option plans. The fair value based method results in recognizing as expense over the vesting period the fair value of all stock-based awards on the date of grant. The Company has elected to continue to use the intrinsic value method.
Had compensation cost for the Company’s option plans been determined in accordance with SFAS 123, the Company’s net income and earnings per share would have been reduced to the pro forma amounts indicated as follows:
| | | Three months ended June, 30 | | Six months ended June 30, | |
| (dollars in thousands except per share amounts) | | 2005 | | 2004 | | 2005 | | 2004 | |
| Net income: | | | | | | | | | |
| As reported | | $ | 5,126 | | $ | 3,880 | | $ | 10,114 | | $ | 7,524 | |
| Pro forma | | $ | 4,913 | | $ | 3,734 | | $ | 9,491 | | $ | 7,019 | |
| | | | | | | | | | | | | | |
| Basic earnings per share: | | | | | | | | | | | | | |
| As reported | | $ | 0.49 | | $ | 0.38 | | $ | 0.97 | | $ | 0.73 | |
| Pro forma | | $ | 0.47 | | $ | 0.36 | | $ | 0.91 | | $ | 0.68 | |
| | | | | | | | | | | | | | |
| Diluted earnings per share: | | | | | | | | | | | | | |
| As reported | | $ | 0.47 | | $ | 0.37 | | $ | 0.94 | | $ | 0.71 | |
| Pro forma | | $ | 0.45 | | $ | 0.35 | | $ | 0.88 | | $ | 0.66 | |
Compensation expense that would have been reported for the six months ended June 30, 2005 for stock options was $719,000, compared to $578,000 for the same six months in 2004. Compensation expense that would have been reported for the three months ended June 30, 2005 for stock options was $229,000, compared to $163,000 for the same three months in 2004.
RECLASSIFICATIONS
Certain amounts previously reported in the 2004 financial statements have been reclassified to conform to the 2005 presentation. Additionally, in the first quarter of 2005, the Company reclassified the reserve for unfunded commitments from the allowance for losses to other liabilities, and reclassified the provision for unfunded commitments from the provision for loan losses to other noninterest expense. These reclassifications did not affect previously reported net income or total shareholders’ equity. Share and per share data for all periods have been adjusted to reflect the nine-for-five stock split which was effective on April 29, 2005 to shareholders of record on April 8, 2005.
Recent Accounting Pronouncements
In May 2003, Financial Accounting Standards Board ("FASB") issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This Statement establishes standards for the classification and measurement of certain financial instruments with characteristics of both liabilities and equity. The Statement also includes required disclosures for financial instruments within its scope. For the Company, the Statement was effective for instruments entered into or modified after May 11, 2004 and otherwise will be effective as of January 1, 2004 except for mandatorily redeemable financial instruments. For certain mandatorily redeemable instruments, the Statement will be effective for the Company on January 1, 2005. The effective date has been deferred indefinitely for certain other types of mandatorily redeemable financial instruments. The Company does not currently have any financial instruments that are within the scope of this Statement.
In December 2003, the Accounting Standards Executive Committee of the AICPA issued Statement of Position No. 03-3 (“SOP 03-3”), Accounting for Certain Loans or Debt Securites Acquired in a Transfer. SOP 03-3 addresses the accounting for differences between the contractual cash flows and the cash flows expected to be collected from purchased loans or debt securities if those differences are attributable, in part, to credit quality. SOP 03-3 requires purchased loans and debt securities to be recorded initially at fair value based on the present value of the cash flows expected to be collected with no carryover of any valuation allowance previously recognized by the seller. Interest income should be recognized based on the effective yield from the cash flows expected to be collected. To the extent that the purchased loans or debt securities experience subsequent deterioration in credit quality, a valuation allowance would be established for any additional cash flows that are not expected to be received. However, if more cash flows subsequently are expected to be received than originally estimated, the effective yield would be adjusted on a prospective basis. SOP 03-3 will be effective for loans and debt securities acquired after December 31, 2004. Although we anticipate that the implementation of SOP 03-3 may require loan system and operational changes to track credit related losses on loans purchased starting in 2005, we do not expect these changes to have a significant effect on the consolidated financial statements.
In March 2004, the Emerging Issues Task Force (“EITF”) Issue No. 03-1 “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” consensus was published. Issue No. 03-1 contained new guidance effectively codifying the provisions of SEC Staff Accounting Bulletin No. 59 and creates a new model that calls for new judgments and additional evidence gathering. In September 2004, the FASB delayed the requirement to record impairment losses under EITF 03-1. The disclosure requirements of EITF 03-1 remain in effect. Management has done an analysis of the impact of this accounting pronouncement, which is discussed in the section of this report entitled, Financial Condition. The Company does not expect the adoption of the final EITF will have a material impact of the Company’s Consolidated Financial Statements.
In December 2004, the FASB issued Statement of Financial Accounting Standards ("SFAS") No. 123 (Revised 2004), Share-Based Payment. The statement requires that compensation cost relating to share-based payment transactions be recognized in financial statements and that this cost be measured based on the fair value of the equity or liability instruments issued. SFAS No. 123 (Revised 2004) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. In April, 2005, the SEC delayed the required adoption date for this standard. The Company will adopt SFAS No 123 (Revised 2004) on January 1, 2006 and is currently evaluating the impact the adoption of the standard will have on the Company's results of operations. The impact on the second quarter and first six months of 2004 and 2005 is discussed in the “Other Financial Notes” section of this report. SEC Staff Accounting Bulletin No. 107, Share-Based Payment provides guidance that will assist issuers in their initial implementation of FASB Statement No. 123 (revised 2004), Share-Based Payment. The SEC staff expressed its views regarding the interaction between Statement 123(R) and certain SEC rules and regulations. SAB 107 also provides the staff’s views on the valuation of share-based payment arrangements for public companies.
In May 2005, the FASB issued SFAS No. 154 Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3. The Statement requires retrospective application to prior periods’ financial statements of voluntary changes in accounting principle, unless it is impracticable to determine either the period - specific effects of the cumulative effect of the change. When it is impracticable to determine the period - specific effects of an accounting change on one or more individual prior periods presented, the new accounting principle is to be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable, with a corresponding adjustment made to the opening balance of retained earnings or other components of equity for that period. If it is impracticable to determine the cumulative effect of applying a change in accounting principle, the new accounting principle is to be applied prospectively from the earliest date practicable. If retrospective application for all periods is impracticable, the method used to report the change and the reason that retrospective application is impracticable are to be disclosed. The Company does not expect the adoption of FASB No. 154 to have a significant effect on the Company’s Consolidated Financial Statements.
The following Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that are subject to risks and uncertainties and include information about possible or assumed future results of operations. Many possible events or factors could affect the future financial results and performance of the company. This could cause results or performance to differ materially from those expressed in our forward-looking statements. Words such as “expects”, “anticipates”, ”believes”, “estimates”, “intends,”“plans,”“assumes,”“projects,”“predicts,”“forecasts,” and variations of such words and other similar expressions are intended to identify such forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions which are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed or forecasted in, or implied by, such forward-looking statements.
Readers of the Company’s Form 10-Q should not rely solely on forward looking statements and should consider all uncertainties and risks discussed throughout this report, as well as those discussed in the Company’s 2004 Annual Report on Form 10-K filed on or about March 15, 2005. These statements are representative only on the date hereof, and the Company undertakes no obligation to update any forward-looking statements made. Some possible events or factors that could occur that may cause differences from expected results include the following: the Company’s loan growth is dependent on economic conditions, as well as various discretionary factors, such as decisions to sell, or purchase certain loans or loan portfolios; or sell or buy participations of loans; the quality and adequacy of management of our borrowers; industry, product and geographic concentrations and the mix of the loan portfolio. The rate of charge-offs and provision expense can be affected by local, regional and international economic and market conditions, concentrations of borrowers, industries, products and geographical conditions, the mix of the loan portfolio and management’s judgements regarding the collectibility of loans. Liquidity requirements may change as a result of fluctuations in assets and liabilities and off-balance sheet exposures, which will impact the capital and debt financing needs of the Company and the mix of funding sources. Decisions to purchase, hold, or sell securities are also dependent on liquidity requirements and market volatility, as well as on and off-balance sheet positions. Factors that may impact interest rate risk include local, regional and international economic conditions, levels, mix, maturities, yields or rates of assets and liabilities and the wholesale and retail funding sources of the Company.
The Company is also exposed to the potential of losses arising from adverse changes in market rates and prices which can adversely impact the value of financial products, including securities, loans, and deposits. In addition, the banking industry in general is subject to various monetary and fiscal policies and regulations, which include those determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation and state regulators, whose policies and regulations could affect the Company’s results.
Other factors that may cause actual results to differ from the forward-looking statements include the following: competition with other local and regional banks, savings and loan associations, credit unions and other nonbank financial institutions, such as investment banking firms, investment advisory firms, brokerage firms, mutual funds and insurance companies, as well as other entities which offer financial services; interest rate, market and monetary fluctuations; inflation; market volatility; general economic conditions; introduction and acceptance of new banking-related products, services and enhancements; fee pricing strategies, mergers and acquisitions and their integration into the Company, civil disturbances or terrorist threats or acts, or apprehension about the possible future occurrences or acts of this type, outbreak or escalation of hostilities in which the United States is involved, any declaration of war by the U.S. Congress or any other national or international calamity, crisis or emergency changes in laws and regulations, recently issued accounting pronouncements, government policies, regulations, and their enforcement (including Bank Secrecy Act-related matters, taxing statutes and regulations); restrictions on dividends that our subsidiaries are allowed to pay to us; the ability to satisfy requirements related to the Sarbanes-Oxley Act and other regulation on internal control; and management’s ability to manage these and other risks. For additional information relating to the risks of the Company's business see "Risk Factors" in the Company's Annual Report on Form 10-K.
Critical accounting policies and estimates
The Company’s discussion and analysis of its financial condition and results of operations is based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company evaluates its estimates, including those related to the adequacy of the allowance for loan losses, intangible assets, valuation of deferred income taxes and contingencies. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. (See caption “Allowance for Loan Losses” for a more detailed discussion). The critical accounting policies and accounting estimates are further discussed in Note 1 of the Company’s 2004 Annual Report.
The following discussion and analysis is designed to provide a better understanding of the significant changes and trends related to the Company and its subsidiaries' financial condition, operating results, asset and liability management, liquidity and capital resources and should be read in conjunction with the Consolidated Financial Statements of the Company and the Notes thereto.
Results Of Operations
Three and Six Months Ended June 30, 2005 Compared With Three and Six Months Ended June 30, 2004
OVERVIEW
For the three months ended June 30, 2005 the Company reported net income of $5,126,000 and for the six months ended June 30, 2005 the Company reported net income of $10,114,000. This compares to $3,880,000 and $7,524,000 for the same periods in 2004 and represents an increase of $1,246,000 or 32% and $2,590,000 or 34% respectively. Basic and fully diluted earnings per share were $0.49 and $0.47 for the three months ended June 30, 2005 and $0.97 and $0.94 for the six months ended June 30, 2005. This compares to basic and fully diluted earnings per share of $0.38 and $0.36 for the three months ended June 30, 2004 and $0.73 and $0.71 for the six months ended June 30, 2004. This represents an increase of $0.11 per share for basic and fully diluted earnings per share for the three months ended June 30, 2004 and $0.24 and $0.23 for the six months ended June 30, 2004. The basic and fully diluted earnings per share are reflective of the nine for five stock split that was announced in March, 2005, with a distribution date of April 29, 2005. The annualized return on average assets was 1.35% and 1.36% for the three and six months ended June 30, 2005 compared to 1.20% and 1.19% for the same periods in 2004. The Company's annualized return on average equity was 18.63% and 18.73% for the three and six months ended June 30, 2005 compared to 16.34% and 16.09% for the same time periods in 2004.
NET INTEREST INCOME
The Company's primary source of income is net interest income and is determined by the difference between interest income and fees derived from earning assets and interest paid on interest bearing liabilities. Net interest income for the three and six months ended June 30, 2005 totaled $16,001,000 and $30,941,000 respectively. This represented an increase of $2,843,000 and $4,996,000 or 22% and 19% when compared to the $13,158,000 and $25,945,000 achieved during the three and six months ended June 30, 2004.
Total interest and fees on earning assets were $21,651,000 and $41,664,000 for the three and six months ended June 30, 2005, an increase of $4,357,000 and $7,464,000 or 25% and 22% respectively from the $17,294,000 and $34,200,000 for the same period in 2004. The level of interest income is affected by changes in volume of and rates earned on interest-earning assets. Interest-earning assets consist primarily of loans, investment securities and federal funds sold. The increase in total interest income for the three and six months ended June 30, 2005 was primarily the result of an increase in volume of interest-earning assets and the yield returned on those assets. Average interest-earning assets for the three and six months ended June 30, 2005 were $1,400,224,000 and $1,372,465,000 compared with $1,198,896,000 and $1,174,503,000 for the three and six months ended June 30, 2004, an increase of $201,328,000 and $197,962,000 or 17% and 17%. Average interest rates earned on interest-earning assets were 6.29% and 6.21% for the three and six months ended June 30, 2005 compared with 5.85% and 5.91% for the same three and six months of 2004, an increase of 44 and 30 basis points or 7.5% and 5.1%. The modest increase in interest rates earned in the second quarter of 2005 compared to the same period in 2004 was primarily the result of an increase in market interest rates during this time period.
Interest expense is a function of the volume and rates paid on interest-bearing liabilities. Interest-bearing liabilities consist primarily of certain deposits and borrowed funds. Total interest expense was $5,650,000 and $10,723,000 for the three and six months ended June 30, 2005, compared with $4,136,000 and $8,255,000 for the three and six months ended June 30, 2004, an increase of $1,514,000 and $2,468,000 or 37% and 30%. This increase was primarily the result of an increase in the volume of interest-bearing liabilities. Average interest-bearing liabilities were $1,122,421,000 and $1,102,645,000 for the three and six months ended June 30, 2005 compared with $987,596,000 and $969,855,000 for the same three and six months in 2004, an increase of $134,825,000 and $132,790,000 or 14% and 14%. Average interest rates paid on interest-bearing liabilities were 2.02% and 1.96% for the three and six months ending June 30, 2005 compared with 1.68% and 1.71% for the same three and six months of 2004, an increase of 34 and 25 basis points or 20.2% and 14.6%. The increase was primarily the result of increased market interest rates and the corresponding repricing of maturing, lower yielding liabilities during the period.
The increase in interest-earning assets and interest-bearing liabilities was primarily the result of increased market penetration within our target markets which has been accomplished by increasing the utilization of existing facilities and the addition of branches in Fresno, California.
The Company's taxable equivalent net interest margin, the ratio of net interest income to average interest-earning assets, was 4.67% and 4.63% for the three and six months ended June 30, 2005 compared with 4.48% and 4.51% for the same period in 2004. Net interest margin provides a measurement of the Company's ability to employ funds profitably during the period being measured. The Company's increase in net interest margin in 2005 was primarily attributable to a gain of 41 and 32 basis points in the loan portfolio yield for the three and six months ended June 30, 2005 and an increase of 40 and 25 basis points in taxable investment securities for the three and six months ended June 30, 2005 as compared to the same time period in 2004. Loans as a percentage of average interest-earning assets remained at 67% for the three and six months ended June 30, 2005 as compared to the same time period in 2004. AVERAGE BALANCES AND RATES EARNED AND PAID
The following table presents condensed average balance sheet information for the Company, together with interest rates earned and paid on the various sources and uses of its funds for each of the periods indicated. Nonaccruing loans are included in the calculation of the average balances of loans, but the nonaccrued interest on such loans is excluded.
AVERAGE BALANCE SHEET & ANALYSIS OF NET INTEREST EARNINGS
| | | Three months ended | | Three months ended | |
| | | June 30, 2005 | | June 30, 2004 | |
| | | Average Balance | | Taxable Equivalent Interest | | Taxable Equivalent Yield/rate | | Average Balance | | Taxable Equivalent Interest | | Taxable Equivalent Yield/rate | |
| | | (Dollars in thousands) | |
Assets | | | | | | | | | | | | | |
| Federal funds sold | | $ | 5,423 | | $ | 37 | | | 2.74 | % | $ | 12,286 | | $ | 30 | | | 0.98 | % |
| Time deposits at other financial institutions | | | 350 | | | 3 | | | 3.44 | | | 350 | | | 2 | | | 2.29 | |
| Taxable investment securities (1) | | | 363,164 | | | 3,806 | | | 4.20 | | | 334,739 | | | 3,175 | | | 3.80 | |
| Nontaxable investment securities (1) | | | 90,250 | | | 1,143 | | | 5.08 | | | 52,905 | | | 695 | | | 5.27 | |
| Loans, gross: (2) | | | 941,037 | | | 16,977 | | | 7.24 | | | 798,616 | | | 13,591 | | | 6.83 | |
| Total interest-earning assets | | $ | 1,400,224 | | $ | 21,966 | | | 6.29 | | $ | 1,198,896 | | $ | 17,493 | | | 5.85 | |
| Allowance for loan losses | | | (13,483 | ) | | | | | | | | (13,847 | ) | | | | | | |
| Cash and due from banks | | | 43,410 | | | | | | | | | 39,503 | | | | | | | |
| Premises and equipment, net | | | 24,407 | | | | | | | | | 18,053 | | | | | | | |
| Interest receivable and other assets | | | 59,949 | | | | | | | | | 50,534 | | | | | | | |
| Total assets | | $ | 1,514,507 | | | | | | | | $ | 1,293,139 | | | | | | | |
| | | | | | | | | | | | | | | | | | | | |
Liabilities And Shareholders' Equity | | | | | | | | | | | | | | | | | | | |
| Negotiable order of withdrawal | | $ | 177,019 | | $ | 38 | | | 0.09 | | $ | 143,762 | | $ | 17 | | | 0.05 | |
| Savings deposits | | | 358,658 | | | 1,104 | | | 1.23 | | | 352,525 | | | 753 | | | 0.86 | |
| Time deposits | | | 391,483 | | | 2,729 | | | 2.80 | | | 351,422 | | | 1,934 | | | 2.21 | |
| Other borrowings | | | 178,765 | | | 1,445 | | | 3.24 | | | 123,391 | | | 1,167 | | | 3.79 | |
| Subordinated Debentures | | | 16,496 | | | 334 | | | 8.12 | | | 16,496 | | | 265 | | | 6.44 | |
| Total interest-bearing liabilities | | | 1,122,421 | | | 5,650 | | | 2.02 | | | 987,596 | | | 4,136 | | | 1.68 | |
| | | | | | | | | | | | | | | | | | | | |
| Noninterest-bearing deposits | | | 270,117 | | | | | | | | | 207,103 | | | | | | | |
| Accrued interest, taxes and other liabilities | | | 11,887 | | | | | | | | | 3,432 | | | | | | | |
| Total liabilities | | | 1,404,425 | | | | | | | | | 1,198,131 | | | | | | | |
| | | | | | | | | | | | | | | | | | | | |
| Total shareholders' equity | | | 110,082 | | | | | | | | | 95,008 | | | | | | | |
| Total liabilities and shareholders' equity | | $ | 1,514,507 | | | | | | | | $ | 1,293,139 | | | | | | | |
| | | | | | | | | | | | | | | | | | | | |
| Net interest income and margin (3) | | | | | $ | 16,316 | | | 4.67 | % | | | | $ | 13,357 | | | 4.48 | % |
| (1) | Tax-equivalent adjustments included in the nontaxable investment securities portfolio are $302,000 and $173,000 for the three months ended June 30, 2005 and 2004. Tax equivalent adjustments included in the taxable investment securities created by the dividends received deduction were $35,000 and $26,000 for the three months ended June 30, 2005 and 2004. The effective tax rate used was 35%. |
| (2) | Amounts of interest earned included loan fees of $922,000 and $629,000 and loan costs of $75,000 and $101,000 for the three months ended June 30, 2005 and 2004, respectively. |
| (3) | Net interest margin is computed by dividing net interest income by total average interest-earning assets. |
AVERAGE BALANCE SHEET & ANALYSIS OF NET INTEREST EARNINGS
| | | Six months ended | | Six months ended | |
| | | June 30, 2005 | | June 30, 2004 | |
| | | Average Balance | | Taxable Equivalent Interest | | Taxable Equivalent Yield/rate | | Average Balance | | Taxable Equivalent Interest | | Taxable Equivalent Yield/rate | |
| | | (Dollars in thousands) | |
Assets | | | | | | | | | | | | | |
| Federal funds sold | | $ | 5,584 | | $ | 72 | | | 2.60 | % | $ | 8,251 | | $ | 41 | | | 1.00 | % |
| Time deposits at other financial institutions | | | 1,112 | | | 15 | | | 2.72 | | | 350 | | | 4 | | | 1.72 | |
| Taxable investment securities (1) | | | 365,925 | | | 7,569 | | | 4.17 | | | 330,265 | | | 6,459 | | | 3.92 | |
| Nontaxable investment securities (1) | | | 84,354 | | | 2,139 | | | 5.11 | | | 50830 | | | 1346 | | | 5.31 | |
| Loans, gross: (2) | | | 915,490 | | | 32,466 | | | 7.15 | | | 784,807 | | | 26,739 | | | 6.83 | |
| Total interest-earning assets | | $ | 1,372,465 | | $ | 42,261 | | | 6.21 | | $ | 1,174,503 | | $ | 34,589 | | | 5.91 | |
| Allowance for loan losses | | | (13,501 | ) | | | | | | | | (13,659 | ) | | | | | | |
| Cash and due from banks | | | 41,856 | | | | | | | | | 39,410 | | | | | | | |
| Premises and equipment, net | | | 23,756 | | | | | | | | | 17,460 | | | | | | | |
| Interest receivable and other assets | | | 58,941 | | | | | | | | | 49,310 | | | | | | | |
| Total assets | | $ | 1,483,517 | | | | | | | | $ | 1,267,024 | | | | | | | |
| | | | | | | | | | | | | | | | | | | | |
Liabilities And Shareholders' Equity | | | | | | | | | | | | | | | | | | | |
| Negotiable order of withdrawal | | $ | 171,764 | | $ | 58 | | | 0.07 | | $ | 139,220 | | | 32 | | | 0.05 | |
| Savings deposits | | | 359,989 | | | 2,109 | | | 1.18 | | | 346,485 | | | 1518 | | | 0.88 | |
| Time deposits | | | 382,754 | | | 5,123 | | | 2.70 | | | 356,538 | | | 3,944 | | | 2.22 | |
| Other borrowings | | | 171,642 | | | 2,788 | | | 3.28 | | | 111,116 | | | 2,232 | | | 4.03 | |
| Subordinated Debentures | | | 16,496 | | | 645 | | | 7.88 | | | 16,496 | | | 529 | | | 6.43 | |
| Total interest-bearing liabilities | | | 1,102,645 | | | 10,723 | | | 1.96 | | | 969,855 | | | 8,255 | | | 1.71 | |
| | | | | | | | | | | | | | | | | | | | |
| Noninterest-bearing deposits | | | 261,743 | | | | | | | | | 198,844 | | | | | | | |
| Accrued interest, taxes and other liabilities | | | 11,150 | | | | | | | | | 4770 | | | | | | | |
| Total liabilities | | | 1,375,538 | | | | | | | | | 1,173,469 | | | | | | | |
| | | | | | | | | | | | | | | | | | | | |
| Total shareholders' equity | | | 107,979 | | | | | | | | | 93,555 | | | | | | | |
| Total liabilities and shareholders' equity | | $ | 1,483,517 | | | | | | | | $ | 1,267,024 | | | | | | | |
| | | | | | | | | | | | | | | | | | | | |
| Net interest income and margin (3) | | | | | $ | 31,538 | | | 4.63 | % | | | | $ | 26334 | | | 4.51 | % |
| (1) | Tax-equivalent adjustments included in the nontaxable investment securities portfolio are $525,000 and $333,000 for the six months ended June 30, 2005 and 2004. Tax equivalent adjustments included in the taxable investment securities created by a dividends received deduction were $72,000 and $57,000 for the six months ended June 30, 2005 and 2004. The effective tax rate used was 35%. |
| (2) | Amounts of interest earned included loan fees of $1,567,000 and $1,140,000 and loan costs of $145,000 and $203,000 for the six months ended June 30, 2005 and 2004, respectively. |
| (3) | Net interest margin is computed by dividing net interest income by total average interest-earning assets. |
NET INTEREST INCOME CHANGES DUE TO VOLUME AND RATE
The following table sets forth, for the periods indicated, a summary of the changes in average asset and liability balances and interest earned and interest paid resulting from changes in average asset and liability balances (volume) and changes in average interest rates and the total net change in interest income and expenses. The changes in interest due to both rate and volume have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each.
Net Interest Income Variance Analysis:
| | | Three months ended | |
| | | June 30, 2005 compared to June 30, 2004 | |
| (Dollar in thousands) | | Volume | | Rate | | Total | |
| (Decrease) increase in interest income: | | | | | | | |
| Federal funds sold | | $ | (24 | ) | $ | 31 | | $ | 7 | |
| Time deposits at other financial institutions | | | - | | | 1 | | | 1 | |
| Taxable investment securities | | | 282 | | | 349 | | | 631 | |
| Tax-exempt investment securities | | | 474 | | | (26 | ) | | 448 | |
| Loans | | | 2,533 | | | 853 | | | 3,386 | |
| Total: | | $ | 3,265 | | $ | 1,208 | | $ | 4,473 | |
| | | | | | | | | | | |
| Increase (decrease) in interest expense: | | | | | | | | | | |
| Interest bearing demand | | $ | 5 | | $ | 16 | | $ | 21 | |
| Savings deposits | | | 13 | | | 338 | | | 351 | |
| Time deposits | | | 238 | | | 557 | | | 795 | |
| Other borrowings | | | 464 | | | (186 | ) | | 278 | |
| Subordinated Debentures | | | - | | | 69 | | | 69 | |
| Total: | | $ | 720 | | $ | 794 | | $ | 1,514 | |
| | | | | | | | | | | |
| Increase (decrease) in net interest income | | $ | 2,545 | | $ | 414 | | $ | 2,959 | |
| | | Six months ended | |
| | | June 30, 2005 compared to June 30, 2004 | |
| (Dollar in thousands) | | Volume | | Rate | | Total | |
| Increase (decrease) in interest income: | | | | | | | |
| Federal funds sold | | $ | (6 | ) | $ | 37 | | $ | 31 | |
| Time deposits at other financial institutions | | | 8 | | | 3 | | | 11 | |
| Taxable investment securities | | | 723 | | | 385 | | | 1,110 | |
| Tax-exempt investment securities | | | 799 | | | (6 | ) | | 793 | |
| Loans | | | 4,599 | | | 1,128 | | | 5,727 | |
| Total: | | $ | 6,125 | | $ | 1,547 | | $ | 7,672 | |
| | | | | | | | | | | |
| Increase (decrease) in interest expense: | | | | | | | | | | |
| Interest bearing demand | | $ | 9 | | $ | 17 | | $ | 26 | |
| Savings deposits | | | 61 | | | 530 | | | 591 | |
| Time deposits | | | 306 | | | 873 | | | 1,179 | |
| Other borrowings | | | 748 | | | (192 | ) | | 556 | |
| Subordinated Debentures | | | - | | | 116 | | | 116 | |
| Total: | | $ | 1,124 | | $ | 1,344 | | $ | 2,468 | |
| | | | | | | | | | | |
| Increase (decrease) in net interest income | | $ | 5,001 | | $ | 203 | | $ | 5,204 | |
PROVISION FOR LOAN LOSSES
The provision for loan losses for the three and six months ended June 30, 2005 was $101,000 and $321,000 compared with $689,000 and $1,304,000 for the three and six months ended June 30, 2004, a decrease of $588,000 and $983,000 or 85% and 75%. See "Allowance for Loan Losses" contained herein. As of June 30, 2005 the allowance for loan losses was $13,404,000 or 1.36% of total loans compared to $13,605,000 or 1.54% of total loans as of December 31, 2004. At June 30, 2005, nonperforming assets totaled $2,325,000 or 0.15% of total assets, nonperforming loans totaled $2,265,000 or 0.23% of total loans and the allowance for loan losses totaled 592% of nonperforming loans. At December 31, 2004, nonperforming assets totaled $4,454,000 or 0.31% of total assets, nonperforming loans totaled $4,394,000 or 0.50% of total loans and the allowance for loan losses totaled 310% of nonperforming loans. The primary reason the provision for loan loss decreased in 2005 compared to 2004 is a lower level of criticized and nonperforming loans. No assurance can be given that nonperforming loans will not increase or that the allowance for loan losses will be adequate to cover losses inherent in the loan portfolio.
NONINTEREST INCOME
Noninterest income decreased by $251,000 and $22,000 or 10% and less than 1% to $2,340,000 and $5,009,000 for the three and six months ended June 30, 2005 compared with $2,591,000 and $5,031,000 in the same period during 2004. Service charges on deposit accounts decreased by $54,000 and $121,000 or 3% and 4% to $1,526,000 and $2,893,000 for the three and six months ended June 30, 2005 compared with $1,580,000 and $3,014,000 for the same period in 2004. The decrease was primarily the result of growth obtained from existing customers in 2005 that resulted in larger balances per customer and a relatively smaller number of fee paying deposit customers. Also, the larger account balances reduced fees paid by deposit customers, especially commercial accounts that utilize account analysis to determine customer fees charged. Other noninterest income decreased by $137,000 or 18% for the three month period ended June 30, 2005 and increased by $135,000 or 9% when compared to the same period in 2004. The primary reason for the increased other income in the current year was the receipt of $539,000 in death benefit proceeds received from a bank owned life insurance policy on a retired executive manager during the first quarter of 2005.
NONINTEREST EXPENSE
Noninterest expenses increased by $1,382,000 and $2,359,000 or 15% and 13% to $10,702,000 and $21,010,000 for the three and six months ended June 30, 2005 compared with $9,320,000 and $18,651,000 for the same period in 2004. The primary components of noninterest expenses were salaries and employee benefits, premises and occupancy expenses, equipment expenses, professional fees, supplies expenses, marketing expenses, intangible amortization and other operating expenses.
For the three and six months ended June 30, 2005, salaries and related benefits increased by $219,000 and $716,000 or 4% and 7% to $5,657,000 and $11,210,000 from the $5,438,000 and $10,494,000 recorded for the same period in 2004. The increase was primarily the result of normal salary progression and increased support staff used in operations and regulatory compliance support functions. Premises and occupancy expense increased by $302,000 and $508,000 or 40% and 33% to $1,066,000 and $2,051,000 for the three and six months ending June 30, 2005 from $764,000 and $1,543,000 during the same period in 2004. The primary reason for the increase in 2005 was the addition of a new customer support center in late 2004. Equipment expenses increased by $297,000 and $329,000 or 40% and 21% to $1,043,000 and $1,901,000 during the three and six months ended June 30, 2005 from the $746,000 and $1,572,000 experienced during the same period in 2004. The additional equipment expenses were primarily the result of branch and department equipment upgrades. When comparing the results of the three and six months ended June 30, 2005 to the three and six months ended June 30, 2004, professional fees increased by $242,000 and $434,000 or 61% and 57%, marketing expenses increased by $177,000 and $124,000 or 116% and 25%, supplies expenses increased by $130,000 and $172,000 or 73% and 43%, intangible amortization expenses decreased by $154,000 and $310,000 or 93% and 93%, and other expenses increased $169,000 and $386,000 or 11% and 13% from 2004 levels. Increased professional fees in 2005 were attributable to the costs associated with the Sarbanes-Oxley Act and Bank Secrecy Act (“BSA”) compliance efforts and increased internal and external audit expenses. The increase in marketing expenses was primarily the result of increased advertising expenses. The increase in supplies expenses was related to increased administrative supplies for the customer support center. The decrease in intangible amortization expense was related to the complete amortization of the premium paid on branch deposits purchased from Bank of America in December 1997. The increase in Other expenses were primarily the result of increased correspondent bank charges caused by increased transaction volumes.
PROVISION FOR INCOME TAXES
The Company recorded an increase of $552,000 and $1,008,000 or 30% and 29% in the income tax provision to $2,412,000 and $4,505,000 for the three and six months ended June 30, 2005 compared to the $1,860,000 and $3,497,000 recorded for the same period in 2004. In 2005 the Company achieved an effective tax rate of 32% and 31% for the three and six months ended June 30, 2005. This compares to a 2004 effective tax rate of 32% for the three and six months ended June 30, 2004. The effective tax rate for the six months ended June 30, 2005 was equivalent to the rate recorded during the same period in 2004 primarily due to the receipt of $539,000 in nontaxable bank owned life insurance death benefits during the first quarter of 2005, increased nontaxable municipality interest income in 2005 that was offset by increased fully taxable income in 2005 over 2004 levels. Excluding the bank owned life insurance death benefits, and the increase in nontaxable municipality interest income, the income tax rate for the six months ended June 30, 2005 would have been slightly below 32%.
Financial Condition
Total assets at June 30, 2005 were $1,544,449,000, an increase of $96,002,000 or 7% compared with total assets of $1,448,447,000 at December 31, 2004. Net loans were $969,561,000 at June 30, 2005, an increase of $98,073,000 or 11% compared with net loans of $871,488,000 at December 31, 2004. Deposits were $1,226,449,000 at June 30, 2005, an increase of $72,292,000 or 6% compared with deposits of $1,154,157,000 at December 31, 2004. The increase in total assets of the Company between December 31, 2004 and June 30, 2005 was primarily funded by an increase in borrowings and deposits. Cash inflows generated from the increased deposits and borrowings were primarily used to fund growth in the loan and investment portfolios, and to fund increased expenditures on branch and support operations facilities and equipment.
Total shareholders' equity was $113,331,000 at June 30, 2005, an increase of $9,850,000 or 10% from the $103,481,000 at December 31, 2004. The growth in shareholders’ equity between December 31, 2004 and June 30, 2005 was primarily achieved through the retention of accumulated earnings.
OFF-BALANCE SHEET COMMITMENTS
The following table shows the distribution of the Company's undisbursed loan commitments at the dates indicated.
| | | June 30, | | December 31, | |
| (Dollars in thousands) | | 2005 | | 2004 | |
| Letters of credit | | $ | 19,523 | | $ | 13,875 | |
| Commitments to extend credit | | | 389,674 | | | 393,039 | |
| Total | | $ | 409,197 | | $ | 406,914 | |
In 2005, the Company reclassified the reserve for unfunded lending commitments from the allowance for loan losses to other liabilities. The reclassifications had no effect on the income before provision for income taxes as reported. The reclassified allowance for loan losses for the three and six months ended June 30, 2005 and 2004, and for the year ended December 31, 2004, is presented on page 23 and the reserve for unfunded commitments is presented on page 25.
CASH VALUE OF LIFE INSURANCE
The Bank maintains certain cash surrender value life insurance policies to help offset some of the cost of employee benefit programs. They are also associated with a salary continuation plan for the Company's executive management and deferred retirement benefits for participating board members. These plans are informally linked with universal life insurance policies maintained by the Bank. Income from these policies is reflected in noninterest income. At June 30, 2005, the Bank held $28,215,000 in cash surrender value life insurance, a decrease of $147,000 from the $28,362,000 maintained at December 31, 2004.
INVESTMENT IN HOUSING TAX CREDIT LIMITED PARTNERSHIPS
The Bank invests in housing tax credit limited partnerships to help meet the Bank’s Community Reinvestment Act low income housing investment requirements as well as to obtain federal and state income tax credits. These partnerships provide the funding for low-income housing projects that might not otherwise be created. The Bank had invested $11,024,000 in these partnerships as of June 30, 2005 and $10,901,000 as of the year ended December 31, 2004, which represents an increase of $123,000 or 1%. The Company does not anticipate making additional significant investments in these partnerships during the remainder of 2005.
INVESTMENT SECURITIES
At June 30, 2005 equity securities included $14.7 million of preferred stock issued by the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation. These issues of preferred stock are tied to various short term indexes ranging from the one year LIBOR interest rate to the five year U.S. Treasury rate. These securities have investment grade credit ratings from the securities rating agencies and are callable by the issuer at par. At June 30, 2005, the unrealized loss on these securities totaled $206,000 compared to a $209,000 unrealized gain at December 31, 2004, after recording a $3,709,000 other than temporary impairment charge during the fourth quarter of 2004.
NONPERFORMING ASSETS
Nonperforming assets include nonaccrual loans, loans 90 days or more past due, restructured loans and other real estate owned.
Nonperforming loans are those which the borrower fails to perform in accordance with the original terms of the obligation and include loans on nonaccrual status, loans past due 90 days or more and restructured loans. The Company generally places loans on nonaccrual status and accrued but unpaid interest is reversed against the current year's income when interest or principal payments become 90 days or more past due unless the outstanding principal and interest is adequately secured and, in the opinion of management, is deemed in the process of collection. Interest income on nonaccrual loans is recorded on a cash basis. Payments may be treated as interest income or return of principal depending upon management's opinion of the ultimate risk of loss on the individual loan. Cash payments are treated as interest income where management believes the remaining principal balance is fully collectible. Additional loans not 90 days past due may also be placed on nonaccrual status if management reasonably believes the borrower will not be able to comply with the contractual loan repayment terms and collection of principal or interest is in question.
A "restructured loan" is a loan on which interest accrues at a below market rate or upon which certain principal has been forgiven so as to aid the borrower in the final repayment of the loan, with any interest previously accrued, but not yet collected, being reversed against current income. Interest is reported on a cash basis until the borrower's ability to service the restructured loan in accordance with its terms is established. The Company had no restructured loans as of the dates indicated in the table below.
The following table summarizes nonperforming assets of the Company at June 30, 2005 and December 31, 2004:
| | | June 30, | | December 31, | |
| | | 2005 | | 2004 | |
| (Dollars in thousands) | | | | | |
| Nonaccrual loans | | $ | 2,265 | | $ | 4,394 | |
| Accruing loans past due 90 days or more | | | - | | | - | |
| Total nonperforming loans | | | 2,265 | | | 4,394 | |
| Other real estate owned | | | 60 | | | 60 | |
| Total nonperforming assets | | $ | 2,325 | | $ | 4,454 | |
| | | | | | | | |
| Nonperforming loans to total loans | | | 0.23 | % | | 0.50 | % |
| Nonperforming assets to total assets | | | 0.15 | % | | 0.31 | % |
Contractual accrued interest income on loans on nonaccrual status as of June 30, 2005 and 2004, that would have been recognized if the loans had been current in accordance with their original terms was approximately $101,000 and $61,000, respectively.
At June 30, 2005, nonperforming assets represented 0.15% of total assets, a decrease of 16 basis points when compared to the 0.31% at December 31, 2004. Nonperforming loans represented 0.23% of total loans at June 30, 2005, a decrease of 27 basis points compared to the 0.50% at December 31, 2004. Nonperforming loans that were secured by first deeds of trust on real property were $2,184,000 and $4,390,000 at June 30, 2005 and December 31, 2004. The decrease in nonperforming loans and nonperforming assets was primarily the result of the continuation of a strong real estate market that has allowed for successful workouts on a few struggling commercial real estate and agricultural properties. Other forms of collateral such as inventory and equipment secured a portion of the nonperforming loans as of each date. No assurance can be given that the collateral securing nonperforming loans will be sufficient to prevent losses on such loans.
At June 30, 2005 and December 31, 2004, the Company had $60,000 invested in one property that had been acquired through foreclosure. The property was carried at the lower of its estimated market value, as evidenced by an independent appraisal, or the recorded investment in the related loan, less estimated selling expenses. At foreclosure, if the fair value of the real estate is less than the Company's recorded investment in the related loan, a charge is made to the allowance for loan losses. The Company does not expect to sell its one remaining property within the next twelve month period due to the fact that the property is subject to a lifetime tenancy for the current occupant of the residence. During the second quarter of 2005, no new foreclosure properties were acquired or sold. No assurance can be given that the Company will sell the remaining property during 2005 or at any time or the amount for which the property might be sold.
Management defines impaired loans, regardless of past due status on loans, as those on which principal and interest are not expected to be collected under the original contractual loan repayment terms. An impaired loan is charged off at the time management believes the collection process has been exhausted. At June 30, 2005 and December 31, 2004, impaired loans were measured based on the present value of future cash flows discounted at the loan's effective rate, the loan's observable market price or the fair value of collateral if the loan is collateral-dependent. Impaired loans at June 30, 2005 were $2,265,000 for which the Company made provisions to the allowance for loan losses of approximately $340,000.
Except for loans that are disclosed above, there were no assets as of June 30, 2005, where known information about possible credit problems of the borrower caused management to have serious doubts as to the ability of the borrower to comply with the present loan repayment terms and which may become nonperforming assets. Given the magnitude of the Company's loan portfolio, however, it is always possible that current credit problems may exist that may not have been discovered by management.
Allowance for Loan Losses
The following table summarizes the loan loss experience of the Company for the six months ended June 30, 2005 and 2004, and for the year ended December 31, 2004.
| | | June 30 | | December 31 | |
| (Dollars in thousands) | | 2005 | | 2004 | | 2004 | |
Allowance for Loan Losses: | | | | | | | |
| Balance at beginning of period | | $ | 13,605 | | $ | 12,524 | | $ | 12,524 | |
| Provision for loan losses | | | 321 | | | 1,304 | | | 2,731 | |
| Charge-offs: | | | | | | | | | | |
| Commercial and agricultural | | | 970 | | | 878 | | | 1,860 | |
| Real estate - mortgage | | | - | | | - | | | - | |
| Consumer | | | 151 | | | 152 | | | 436 | |
| Total charge-offs | | | 1,121 | | | 1,030 | | | 2,296 | |
| Recoveries | | | | | | | | | | |
| Commercial and agricultural | | | 470 | | | 143 | | | 344 | |
| Real-Estate - mortgage | | | - | | | - | | | 12 | |
| Consumer | | | 129 | | | 140 | | | 290 | |
| Total recoveries | | | 599 | | | 283 | | | 646 | |
| Net charge-offs | | | 522 | | | 747 | | | 1,650 | |
| Balance at end of period | | $ | 13,404 | | $ | 13,081 | | $ | 13,605 | |
| | | | | | | | | | | |
| Loans outstanding at period-end | | $ | 982,965 | | $ | 817,731 | | $ | 885,093 | |
| Average loans outstanding | | $ | 915,490 | | $ | 784,807 | | $ | 813,050 | |
| | | | | | | | | | | |
| Annualized net charge-offs to average loans | | | 0.11 | % | | 0.19 | % | | 0.20 | % |
| Allowance for loan losses | | | | | | | | | | |
| To total loans | | | 1.36 | % | | 1.60 | % | | 1.54 | % |
| To nonperforming loans | | | 591.78 | % | | 264.74 | % | | 309.63 | % |
| To nonperforming assets | | | 576.51 | % | | 261.54 | % | | 305.46 | % |
The Company maintains an allowance for loan losses at a level considered by management to be adequate to cover the inherent risks of loss associated with its loan portfolio under prevailing and anticipated economic conditions. In determining the adequacy of the allowance for loan losses, management takes into consideration growth trends in the portfolio, examination of financial institution supervisory authorities, prior loan loss experience for the Company, concentrations of credit risk, delinquency trends, general economic conditions, the interest rate environment and internal and external credit reviews. In addition, the risks management considers vary depending on the nature of the loan. The normal risks considered by management with respect to agricultural loans include the fluctuating value of the collateral, changes in weather conditions and the availability of adequate water resources in the Company's local market area. The normal risks considered by management with respect to real estate construction loans include fluctuation in real estate values, the demand for improved commercial and industrial properties and housing, the availability of permanent financing in the Company's market area and borrowers' ability to obtain permanent financing. The normal risks considered by management with respect to real estate mortgage loans include fluctuations in the value of real estate. Additionally, the Company relies on data obtained through independent appraisals for significant properties to determine loss exposure on nonperforming loans.
The balance in the allowance is affected by the amounts provided from operations, amounts charged off and recoveries of loans previously charged off. The Company recorded a provision for loan losses in the first six months of 2005 of $321,000 compared with $1,304,000 in the same period of 2004. The decrease was related to an overall improvement in graded loans in the first half of 2005 when compared to the same period in 2004. The Company's charge-offs, net of recoveries, were $522,000 for the six months ended June 30, 2005 compared with $747,000 for the same six months in 2004. The decrease primarily occurred due to increased recoveries obtained from the commercial and agricultural segment of the loan portfolio. The increased recoveries in this segment were primarily attributable to recoveries specific to individual borrowers rather than market or industry conditions that apply to a broader customer base.
As of June 30, 2005, the allowance for loan losses was $13,404,000 or 1.36% of total loans outstanding, compared with $13,605,000 or 1.54% of total loans outstanding as of December 31, 2004 and $13,081,000 or 1.60% of total loans outstanding as of June 30, 2004.
The Company uses a method developed by management for determining the appropriate level of its allowance for loan losses. This method applies relevant risk factors to the entire loan portfolio, including nonperforming loans. The methodology is based, in part, on the Company's loan grading and classification system. The Company grades its loans through internal reviews and periodically subjects loans to external reviews which then are assessed by the Company's audit committee and management. Credit reviews are performed on a monthly basis and the quality grading process occurs on a quarterly basis. Risk factors applied to the performing loan portfolio are based on the Company's past loss history considering the current portfolio's characteristics, current economic conditions and other relevant factors. General reserves are applied to various categories of loans at percentages ranging up to 1.8% based on the Company's assessment of credit risks for each category. Risk factors are applied to the carrying value of each classified loan: (i) loans internally graded "Watch" or "Special Mention" carry a risk factor from 1.0% to 2.0%; (ii) "Substandard" loans carry a risk factor from 15% to 40% depending on collateral securing the loan, if any; (iii) "Doubtful" loans carry a 50% risk factor; and (iv) "Loss" loans are charged off 100%. In addition, a portion of the allowance is specially allocated to identified problem credits. The analysis also includes reference to factors such as the delinquency status of the loan portfolio, inherent risk by type of loans, industry statistical data, recommendations made by the Company's regulatory authorities and outside loan reviewers, and current economic environment. Important components of the overall credit rating process are the asset quality rating process and the internal loan review process.
The allowance is based on estimates and ultimate future losses may vary from current estimates. It is always possible that future economic or other factors may adversely affect the Company's borrowers, and thereby cause loan losses to exceed the current allowance. In addition, there can be no assurance that future economic or other factors will not adversely affect the Company's borrowers, or that the Company's asset quality may not deteriorate through rapid growth, failure to enforce underwriting standards, failure to maintain appropriate underwriting standards, failure to maintain an adequate number of qualified loan personnel, failure to identify and monitor potential problem loans or for other reasons, and thereby cause loan losses to exceed the current allowance.
The allocation of the allowance to loan categories is an estimate by management of the relative risk characteristics of loans in those categories. No assurance can be given that losses in one or more loan categories will not exceed the portion of the allowance allocated to that category or even exceed the entire allowance.
RESERVE FOR UNFUNDED LENDING COMMITMENTS
The reserve for unfunded lending commitments at June 30, 2005 and 2004, and December 31, 2004, is presented below.
| | | June 30 | | December 31 | |
| | | 2005 | | 2004 | | 2004 | |
| | | (Dollars in thousands) | |
Balance at the beginning of period | | $ | 679 | | $ | 739 | | $ | 739 | |
| Reduction in accruals for credit commitment losses | | | (12 | ) | | (63 | ) | | (60 | ) |
| Balance at the end of period | | $ | 667 | | $ | 676 | | $ | 679 | |
EXTERNAL FACTORS AFFECTING ASSET QUALITY
As a result of the Company's loan portfolio mix, the future quality of its assets could be affected by adverse economic trends in its region or in the agricultural community. These trends are beyond the control of the Company.
California is an earthquake-prone region. Accordingly, a major earthquake could result in material loss to the Company. At times the Company's service area has experienced other natural disasters such as floods and droughts. The Company's properties and substantially all of the real and personal property securing loans in the Company's portfolio are located in California. The Company faces the risk that many of its borrowers face uninsured property damage, interruption of their businesses or loss of their jobs from earthquakes, floods or droughts. As a result these borrowers may be unable to repay their loans in accordance with their terms and the collateral for such loans may decline significantly in value. The Company's service area is a largely agricultural region and therefore is highly dependent on a reliable supply of water for irrigation purposes. The area obtains nearly all of its water from the run-off of melting snow in the mountains of the Sierra Nevada to the east. Although such sources have usually been available in the past, water supply can be adversely affected by light snowfall over one or more winters or by any diversion of water from its present natural courses. Any such natural disaster could impair the ability of many of the Company's borrowers to meet their obligations to the Company.
Parts of California have experienced significant floods in the late 1990s. No assurance can be given that future flooding will not have an adverse impact on the Company and its borrowers and depositors.
LIQUIDITY
In order to maintain adequate liquidity, the Company must have sufficient resources available at all times to meet its cash flow requirements. The need for liquidity in a banking institution arises principally to provide for deposit withdrawals, the credit needs of its customers and to take advantage of investment opportunities as they arise. The Company may achieve desired liquidity from both assets and liabilities. The Company considers cash and deposits held in other banks, federal funds sold, other short term investments, maturing loans and investments, payments of principal and interest on loans and investments and potential loan sales as sources of asset liquidity. Deposit growth and access to credit lines established with correspondent banks and market sources of funds are considered by the Company as sources of liability liquidity. The holding company’s primary source of liquidity is from dividends received from the Bank. Dividends from the Bank are subject to certain regulatory restrictions.
The Company reviews its liquidity position on a regular basis based upon its current position and expected trends of loans and deposits. These assets include cash and deposits in other banks, time deposits at other financial institutions, available-for-sale securities and federal funds sold. The Company's liquid assets totaled $307,998,000 and $330,358,000 on June 30, 2005 and December 31, 2004, respectively, and constituted 20% and 23% of total assets on both those dates. Liquidity is also affected by the collateral requirements of its public deposits and certain borrowings. Total pledged securities were $376,417,000 at June 30, 2005 compared with $321,688,000 at December 31, 2004.
Although the Company's primary sources of liquidity include liquid assets and a stable deposit base, the Company maintains lines of credit with the Federal Reserve Bank of San Francisco, Federal Home Loan Bank of San Francisco, Pacific Coast Bankers' Bank, Union Bank of California, Wells Fargo Bank and First Tennessee Bank aggregating $280,788,000 of which $168,588,000 was outstanding as of June 30, 2005 and $217,832,000 of which $155,326,000 was outstanding as of December 31, 2004. The increase in borrowings outstanding during the first half of 2005 produced an inflow of funds that were used to purchase additional investment securities. Management believes that the Company maintains adequate amounts of liquid assets to meet its liquidity needs. The Company's liquidity might be insufficient if deposit withdrawals were to exceed anticipated levels. Deposit withdrawals can increase if a company experiences financial difficulties, receives adverse publicity for other reasons, or if its pricing, products or services are not competitive with those offered by other institutions.
CAPITAL RESOURCES
Capital serves as a source of funds and helps protect depositors against potential losses. The primary source of capital for the Company has been internally generated capital through retained earnings. The Company's shareholders' equity increased by $9,850,000 or 9.5% from December 31, 2004 to June 30, 2005. This increase was caused by the retention of accumulated earnings.
The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate mandatory and possibly additional discretionary actions by the regulators that, if undertaken, could have a material adverse effect on the Company’s financial statements. Management believes, as of June 30, 2005, that the Company and the Bank met all applicable capital requirements. The Company’s leverage capital ratio at June 30, 2005 was 8.44% as compared with 8.46% as of December 31, 2004. The Company’s total risk based capital ratio at June 30, 2005 was 11.53% as compared to 11.55% as of December 31, 2004.
The Company’s and Bank’s actual capital amounts and ratios met all regulatory requirements as of June 30, 2005 and were summarized as follows:
| Dollars in thousands | | Actual | | For Capital Adequacy Purposes | | To Be Well Capitalized Under Prompt Corrective Action Provisions: | |
| Consolidated | | Amount | | Ratio | | | | | | | | | |
| As of June 30, 2005 | | | | | | | | | | | | | |
| Total capital (to risk weighted assets) | | $ | 141,751 | | | 11.53 | % | $ | 98,340 | | | 8.0 | % | $ | 122,925 | | | 10.0 | % |
| Tier 1 capital (to risk weighted assets) | | | 127,680 | | | 10.39 | | | 49,170 | | | 4.0 | | | 73,755 | | | 6.0 | |
| Leverage ratio* | | | 127,680 | | | 8.44 | | | 60,522 | | | 4.0 | | | 75,653 | | | 5.0 | |
| | | | | | | | | | | | | | | | | | | | |
| The Bank: | | | | | | | | | | | | | | | | | | | |
| As of June 30, 2005 | | | | | | | | | | | | | | | | | | | |
| Total capital (to risk weighted assets) | | $ | 129,420 | | | 10.55 | % | $ | 98,164 | | | 8.0 | % | $ | 122,705 | | | 10.0 | % |
| Tier 1 capital (to risk weighted assets) | | | 115,349 | | | 9.40 | | | 49,082 | | | 4.0 | | | 73,623 | | | 6.0 | |
| Leverage ratio* | | | 115,349 | | | 7.64 | | | 60,380 | | | 4.0 | | | 75,475 | | | 5.0 | |
* The leverage ratio consists of Tier 1 capital divided by adjusted quarterly average assets. The minimum leverage ratio is 3 percent for banking organizations that do not anticipate significant growth and that have well-diversified risk, excellent asset quality and in general, are considered top-rated banks.
The Company issues dividends solely at the discretion of the Company’s Board of Directors, subject to compliance with regulatory requirements. In order to pay any cash dividends, the Company must receive payments of dividends or management fees from the Bank. There are certain regulatory limitations on the payment of cash dividends by banks.
On October 26, 2004, the Bank entered into a written agreement (the Agreement) with the FRBSF relating to certain deficiencies identified by the FRB with respect to the Bank’s compliance with BSA and other applicable laws and regulations relating to anti-money laundering (“AML”). CCOW has filed a Form 8-K containing the Bank’s Agreement with the FRBSF with the SEC.
The banking industry, including the Bank, is subject to significantly increased regulatory scrutiny and enforcement regarding BSA matters. Under the Agreement, the Bank will, among other actions to be taken, (i) develop a written program designed to improve the Bank’s system of internal controls to ensure compliance with applicable provisions of the BSA; (ii) develop an enhanced written customer due diligence program designed to reasonably ensure the identification and reporting of all known or suspected violations of law and suspicious transactions against or involving the Bank; (iii) establish enhanced written policies and procedures designed to strengthen the Bank’s internal controls and audit program, and (iv) submit quarterly progress reports to the FRBSF detailing actions taken to secure compliance with the Agreement.
The Bank has already made significant progress in addressing the deficiencies identified by the FRBSF. The compliance effort will entail certain additional expenditures. In addition, while the Agreement is in place, its effect may be to limit the Bank’s ability to engage in certain expansionary activity. Neither of these effects are expected to have a material adverse impact on the financial condition nor results of operations of the Bank or the Company.
DEPOSITS
Deposits are the Company's primary source of funds. At June 30, 2005, the Company had a deposit mix of 29% in savings deposits, 34% in time deposits, 14% in interest-bearing checking accounts and 23% in noninterest-bearing demand accounts. Noninterest-bearing demand deposits enhance the Company's net interest income by lowering its costs of funds.
The Company obtains deposits primarily from the communities it serves. No material portion of its deposits has been obtained from or is dependent on any one person or industry. The Company's business is not seasonal in nature. The Company accepts deposits in excess of $100,000 from customers. These deposits are priced to remain competitive. At June 30, 2005, the Company had brokered deposits of $20,966,000 and $99,000 at December 31, 2004.
Maturities of time certificates of deposits of $100,000 or more outstanding at June 30, 2005 and December 31, 2004 are summarized as follows:
| | | June 30, 2005 | | December 31, 2004 | |
| | | (Dollars in thousands) | |
| Three months or less | | $ | 72,393 | | $ | 77,105 | |
| Over three to six months | | | 30,591 | | | 20,366 | |
| Over six to twelve months | | | 55,971 | | | 38,086 | |
| Over twelve months | | | 57,140 | | | 31,183 | |
| Total | | $ | 216,095 | | $ | 166,740 | |
Borrowed Funds
Borrowed funds increased by $10,645,000 or 6% to $174,764,000 at June 30, 2005 compared to the $164,119,000 outstanding at December 31, 2004. The increase in borrowed funds during the first six months of 2005 was primarily due to the use of a leveraged investment strategy that utilizes additional FHLB borrowings to fund purchases of investment securities within the Bank’s investment portfolio.
Return on Equity and Assets
| | | Six months ended | | Six months ended | | Year ended | |
| | | June 30 | | June 30 | | December 31 | |
| | | 2005 | | 2004 | | 2004 | |
| Annualized return on average assets | | | 1.36 | % | | 1.20 | % | | 0.94 | % |
| Annualized return on average equity | | | 18.73 | % | | 16.34 | % | | 12.69 | % |
| Dividend payout ratio | | | 10.31 | % | | 7.58 | % | | 9.00 | % |
| Average equity to average assets | | | 7.28 | % | | 7.35 | % | | 7.41 | % |
Impact of Inflation
The primary impact of inflation on the Company is its effect on interest rates. The Company’s primary source of income is net interest income which is affected by changes in interest rates. The Company attempts to limit inflation’s impact on its net interest margin through management of rate sensitive assets and liabilities and the analysis of interest rate sensitivity. The effect of inflation on premises and equipment, as well as on interest expenses, has not been significant for the periods covered in this report.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
In the normal course of business, the Company is exposed to market risk which includes both price and liquidity risk. Price risk is created from fluctuations in interest rates and the mismatch in repricing characteristics of assets, liabilities, and off balance sheet instruments at a specified point in time. Mismatches in interest rate repricing among assets and liabilities arise primarily through the interaction of the various types of loans versus the types of deposits that are maintained as well as from management's discretionary investment and funds gathering activities. Liquidity risk arises from the possibility that the Company may not be able to satisfy current and future financial commitments or that the Company may not be able to liquidate financial instruments at market prices. Risk management policies and procedures have been established and are utilized to manage the Company's exposure to market risk. Quarterly testing of the Company’s assets and liabilities under both increasing and decreasing interest rate environments are performed to insure the Company does not assume a magnitude of risk that is outside approved policy limits.
The Company’s success is largely dependent upon its ability to manage interest rate risk. Interest rate risk can be defined as the exposure of the Company’s net interest income to adverse movements in interest rates. Although the Company manages other risks, such as credit and liquidity risk in the normal course of its business, management considers interest rate risk to be its most significant market risk and could potentially have the largest material effect on the Company’s financial condition and results of operations. Correspondingly, the overall strategy of the Company is to manage interest rate risk, through balance sheet structure, to be interest rate neutral.
The Company’s interest rate risk management is the responsibility of the Asset/Liability Management Committee (ALCO), which reports to the Board of Directors. ALCO establishes policies that monitors and coordinates the Company’s sources, uses and pricing of funds. ALCO is also involved in formulating the economic projections for the Company’s budget and strategic plan. ALCO sets specific rate sensitivity limits for the Company. ALCO monitors and adjusts the Company’s exposure to changes in interest rates to achieve predetermined risk targets that it believes are consistent with current and expected market conditions. Balance sheet management personnel monitor the asset and liability changes on an ongoing basis and provide report information and recommendations to the ALCO committee in regards to those changes.
It is the opinion of management there has been no material change in the Company’s market risk during the first half of 2005 when compared to the level of market risk at December 31, 2004. If interest rates were to suddenly and materially fall from levels experienced during the first half of 2005, the Company could become susceptible to an increased level of market risk.
Evaluation Of Disclosure Controls And Procedures
Under the supervision and with the participation of the Company’s management, including its chief executive officer and chief financial officer, the Company conducted an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures as defined by Rule 13a-15(e) under the Securities Exchange Act of 1934.
Based on the evaluation, the chief executive officer and chief financial officer concluded that as of the end of the period covered by this report the disclosure controls and procedures were adequate and effective, and that the material information required to be included in this report, including information from the Company’s consolidated subsidiaries, was properly recorded, processed, summarized and reported, and was made known to the chief executive officer and chief financial officer by others within the Company in a timely manner, particularly during the period when this quarterly report on Form 10-Q was being prepared.
Changes In Internal Control over Financial Reporting
There was no change in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II - Other Information
The Company is a party to routine litigation in the ordinary course of its business. In the opinion of management, pending and threatened litigation is not likely to have a material adverse effect on the financial condition or results of operations of the Company.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
None.
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Securities Holders.
| (a.) | Our Annual Meeting of Shareholders for 2005 was held April 26, 2005. The number of shares represented in person or by proxy and constituting a quorum was 4,198,581, which equaled approximately 72% of the shares outstanding. |
| (b.) | The following are the results of the election of directors in Class III of the Board: |
Election of directors | Votes For | Votes Withheld |
| G. Michael Graves | 4,039,094 | 159,487 |
| Tom A.L. Van Groningen | 4,132,445 | 66,136 |
| Curtis R. Grant | 4,131,491 | 67,090 |
| David Bonnar | 4,062,616 | 135,965 |
In the opinion of management, there is no additional information relating to these periods being reported which warrants inclusion in the report.
See Exhibit Index
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
CAPITAL CORP OF THE WEST
(Registrant)
| Date: August 4, 2005 | By /s/ Thomas T. Hawker |
| | Thomas T. Hawker |
| | President and |
| | Chief Executive Officer |
| Date: August 4, 2005 | By /s/ R. Dale McKinney |
| | R. Dale McKinney |
| | Chief Financial Officer |
Exhibit Description
