“Our focus on building a strong relationship lending team and expanding our East Bay market continues to prove its value to our franchise,” said Walter Kaczmarek, President and Chief Executive Officer. “Despite the continuing problems in the national and regional economy, we ended the year with an after-tax profitable quarter and positive earnings for the full year. We anticipate some of the issues that impacted operations in 2008 will continue in 2009, including pressure on margins from low interest rates, declining real estate values and overall economic contraction. Our focus on relationship lending, coupled with the CPP capital infusion completed in November 2008, has allowed us to continue to provide lending to our customers and build value for our shareholders.”
Balance Sheet and Capital Management
Heritage’s assets totaled $1.5 billion at December 31, 2008, compared to $1.35 billion a year ago, and $1.51 billion at September 30, 2008. Total loans were $1.25 billion at December 31, 2008, compared to $1.04 billion at December 31, 2007, and $1.25 billion at September 30, 2008. Deposits totaled $1.15 billion at December 31, 2008, compared to $1.06 billion at December 31, 2007, and $1.19 billion at September 30, 2008.
The securities portfolio of $104.5 million at December 31, 2008 consisted primarily of short term U.S. Treasury securities, U.S. government sponsored entities’ debt securities, mortgage-backed securities, collateralized mortgage obligations, and municipal bonds. The Company has no direct exposure to so-called subprime loans or securities, nor does it own any Fannie Mae or Freddie Mac equity securities.
The Company’s loan portfolio at December 31, 2008 consisted of 42% commercial loans, 32% commercial real estate mortgage loans, 21% land and construction, and 5% home equity and consumer loans.
Total deposits decreased $32.1 million in the fourth quarter of 2008, compared to the third quarter of 2008, primarily due to lower balances in title insurance company, escrow, and real estate exchange facilitators’ accounts. These decreases were partially offset by an $11.2 million increase in brokered deposits.
Shareholders’ equity increased to $184.3 million, or $8.37 tangible book value per common share, at December 31, 2008, compared to $164.8 million, or $9.20 tangible book value per share, a year ago, and increased from $144.3 million, or $8.18 tangible book value per share, at September 30, 2008. Capital ratios continue to be above the well-capitalized guidelines established by regulatory agencies. The leverage ratio at December 31, 2008 was 11.03%, compared to 11.05% at December 31, 2007, and 8.27% at September 30, 2008.
On November 21, 2008, the Company completed its $40 million capital raise through the issuance of preferred stock and common stock warrants to the U.S. Department of Treasury. This transaction was part of the U.S. Treasury’s Capital Purchase Program to encourage U.S. financial institutions to build capital to increase the flow of financing to U.S. businesses and consumers and to support the U.S. economy. The preferred shares will pay a 5% dividend for the first five years, after which the rate will increase to 9% if the preferred shares are not redeemed by the Company. Proceeds from this capital infusion enhanced the Company’s already well-capitalized position and increased our ability to meet the needs of our customers and the communities we serve.
From the time the Company received the investment from the Treasury through December 31, 2008, the Company made $32 million (or 80% of CPP money) in new loan commitments and $46 million in renewed loan commitments. Total loans increased $212 million, or 20%, for the year ended December 31, 2008.
Credit Quality
Primarily due to a softening in the real estate market, which is expected to continue well into 2009, nonperforming assets (“NPAs”) increased by $16.0 million from September 30, 2008 to December 31, 2008. Nonperforming assets totaled $41.1 million, or 2.74% of total assets, at December 31, 2008, compared to $4.5 million, or 0.34% of total assets at December 31, 2007, and $25.1 million, or 1.66% of total assets at September 30, 2008.
Other real estate owned (“OREO”) was $660,000 at December 31, 2008, compared to $1.1 million at December 31, 2007, and $970,000 at September 30, 2008. Two OREO properties were sold during the fourth quarter of 2008, resulting in a net loss of $93,000.
Net charge-offs in the fourth quarter of 2008 were $1.8 million or 0.59% of average loans, compared to net recoveries of $21,000 or (0.01%) of average loans in the fourth quarter of 2007. Net charge-offs in the third quarter of 2008 were $129,000 or 0.04% of average loans. For the full year, net charge-offs totaled $2.7 million, or 0.23% of average loans, compared to net recoveries of $825,000 or (0.10%) of average loans in 2007.
The allowance for loan losses was $25.0 million at December 31, 2008, representing 2.00% of total loans and 62% of nonperforming loans, compared to $12.2 million at December 31, 2007, representing 1.18% of total loans and 353% of nonperforming loans. At September 30, 2008, the allowance for loan losses was $22.3 million or 1.79% of total loans and 93% of nonperforming loans.
Operating Results
Net income during 2008 was impacted by the net interest margin compression, a higher provision for loan losses, and lower noninterest income resulting from the Company’s strategic decision to retain, rather than sell, SBA loan production.
Net interest income decreased to $12.4 million in the fourth quarter of 2008 from $13.8 million in the fourth quarter of 2007, and $13.0 million in the third quarter of 2008. The fourth quarter of 2008 net interest margin was 3.64%, down 19 basis points, compared to 3.83% for the third quarter this year, and down 106 basis points from 4.70% in the fourth quarter a year ago. For 2008, the net interest margin decreased 92 basis points to 3.94% from 4.86% in 2007. Decreases in the net interest margin are primarily the result of the 500 basis points decline in short-term interest rates from September 18, 2007 through December 31, 2008.
Noninterest income was $1.8 million for the fourth quarter of 2008, compared to $1.6 million for the fourth quarter of 2007, and $1.7 million for the prior quarter. Noninterest income was $6.8 million in 2008, compared to $8.1 million a year ago. Gains on sales of SBA loans were $0 in 2008, compared to $1.8 million in 2007. Noninterest income was primarily comprised of loan servicing income, the increase in cash surrender value of Company owned life insurance, and service charges on deposit accounts.
Noninterest expense was $10.4 million for the fourth quarter of 2008, compared to $10.2 million for the fourth quarter of 2007, and $10.4 million for the third quarter of 2008. Noninterest expense increased to $42.4 million in 2008, compared to $37.5 million in 2007. Operating expenses increased in 2008 due to the full year impact of the acquisition of Diablo Valley Bank on June 20, 2007, the new office in Walnut Creek, the addition of experienced banking professionals, the write-off of leasehold improvements in the third quarter of 2008 due to the consolidation of our two offices in Los Altos, higher regulatory assessments, and an increase in legal fees and OREO expense.
The income tax benefit for the quarter and the year ended December 31, 2008 was $1.4 million, as compared to income tax expense of $1.7 million and $8.1 million for the same periods in 2007. The negative effective income tax rates for the quarter and year ended December 31, 2008 were due to reduced pre-tax earnings. The negative tax rates correspond to a benefit, rather than expense, of $1.4 million for the quarter and for the year ended December 31, 2008. The effective income tax rates for the fourth quarter and year ended 2007 were 37.5% and 36.6%, respectively. The difference in the effective tax rate compared to the combined federal and state statutory tax rate of 42% is primarily the result of the Company’s investment in life insurance policies whose earnings are not subject to taxes, tax credits related to investments in low income housing limited partnerships and investments in tax-free municipal securities. The effective tax rates in 2008 are lower compared to 2007 because pre-tax income decreased substantially while benefits from tax advantaged investments did not.
The efficiency ratio was 73.40% in the fourth quarter of 2008, compared to 70.56% in the third quarter of 2008, and 66.17% in the fourth quarter of 2007. The efficiency ratio in 2008 increased to 72.71% from 62.81% a year ago. The efficiency ratio increased in 2008 primarily due to compression of the net interest margin, a decrease in noninterest income, and an increase in expenses, as discussed above.
The annualized returns on average assets (ROAA) and average equity (ROAE) for the fourth quarter of 2008 were 0.19% and 1.71%, compared to 0.84% and 6.62% for the fourth quarter of 2007, respectively. ROAA and ROAE were 0.12% and 1.15% for 2008, compared to 1.18% and 9.47% for 2007, respectively. The annualized returns on average tangible assets (ROATA) and average tangible equity (ROATE) for the fourth quarter of 2008 were 0.19% and 2.42%, compared to 0.87% and 9.26% for the fourth quarter of 2007, respectively. ROATA and ROATE were 0.13% and 1.67% for 2008, compared to 1.21% and 11.43% for 2007, respectively.
Heritage Commerce Corp, a bank holding company established in February 1998, is the parent company of Heritage Bank of Commerce, established in 1994 and headquartered in San Jose with full-service branches in Los Gatos, Fremont, Danville, Pleasanton, Walnut Creek, Morgan Hill, Gilroy, Mountain View, and Los Altos. Heritage Bank of Commerce is an SBA Preferred Lender with loan production offices in Fresno, Sacramento, Oakland, and Santa Rosa, California. For more information, please visit www.heritagecommercecorp.com.