UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
| | x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 2008. |
| | ¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____ TO . |
Commission file number: 000-32987
UNITED SECURITY BANCSHARES
(Exact name of registrant as specified in its charter)
| CALIFORNIA | | 91-2112732 |
| (State or other jurisdiction of | | (I.R.S. Employer |
| incorporation or organization) | | Identification No.) |
| 2126 Inyo Street, Fresno, California | | 93721 |
| (Address of principal executive offices) | | (Zip Code) |
Registrant’s telephone number, including area code (559) 248-4943
| Securities registered pursuant to Section 12(b) of the Act: | Common Stock, no par value on Nasdaq |
| | (Title of Class) |
Securities registered pursuant to Section 12(g) of the Act: NONE
Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes ¨ No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Securities Act.
Yes ¨ No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing for the past 90 days.
Yes x No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrants knowledge, in the definitive proxy or information statements incorporated by reference in Part III of this form 10-K or any amendment to this Form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Small reporting company ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x
Aggregate market value of the Common Stock held by non-affiliates as of the last business day of the registrant's most recently completed second fiscal quarter - June 30, 2008: $121,168,727
Shares outstanding as of February 28, 2008: 12,009,884
DOCUMENTS INCORPORATED BY REFERENCE
Certain portions of the Definitive Proxy Statement for the 2009 Meeting of Part III, Items 10, 11, 12, 13 and 14
Shareholders is incorporated by reference into Part III.
UNITED SECURITY BANCSHARES
TABLE OF CONTENTS
| PART I: | | | 3 |
| | | | |
| | Item 1 – | Business | 3 |
| | Item 1A – | Risk Factors | 16 |
| | Item 1B – | Unresolved Staff Comments | 22 |
| | Item 2 – | Properties | 22 |
| | Item 3 - | Legal Proceedings | 23 |
| | Item 4 - | Submission of Matters to a Vote of Security Holders | 23 |
| | | | |
| PART II: | | | 23 |
| | | | |
| | Item 5 - | Market for the Registrant's Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities | 23 |
| | Item 6 - | Selected Financial Data | 27 |
| | Item 7 - | Management's Discussion and Analysis of Financial Condition and Results of Operations | 28 |
| | Item 7A - | Quantitative and Qualitative Disclosure About Market Risk | 62 |
| | Item 8 - | Financial Statements and Supplementary Data | 66 |
| | Item 9 - | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure | 109 |
| | Item 9A – | Controls and Procedures | 109 |
| | Item 9B – | Other Information | 111 |
| | | | |
| PART III: | | | 111 |
| | | | |
| | Item 10 – | Directors, Executive Officers, and Corporate Governance | 111 |
| | Item 11 - | Executive Compensation | 111 |
| | Item 12 - | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters | 111 |
| | Item 13 - | Certain Relationships and Related Transactions, and Director Independence | 111 |
| | Item 14 – | Principal Accounting Fees and Services | 111 |
| | | | |
| PART IV: | | | 112 |
| | | | |
| | Item 15 – | Exhibits and Financial Statement Schedules | 112 |
PART 1
Certain matters discussed or incorporated by reference in this Annual Report of Form 10-K including, but not limited to, those described in "Item 7 - Management's Discussion and Analysis of Financial Condition and Results of Operations", are forward-looking statements as defined under the Securities Litigation Reform Act of 1995 that are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties include, among others, (1) competitive pressure in the banking industry increases significantly; (2) changes in the interest rate environment which may reduce margins and devalue assets; (3) general economic conditions, either nationally or regionally, are less favorable than expected, resulting in, among other things, a deterioration in credit quality; (4) changes in the regulatory environment; (5) changes in business conditions and inflation; (6) changes in securities markets; (7) asset/liability matching risks and liquidity risks; (8) loss of key personnel; and (9) operational interruptions including data processing systems failure and fraud. Therefore, the information set forth therein should be carefully considered when evaluating the business prospects of the Company.
Item 1 - Business
General
United Security Bancshares (the “Company”) is a California corporation incorporated during March of 2001and is registered with the Board of Governors of the Federal Reserve System as a bank holding company under the Bank Holding Company Act of 1956, as amended. The Company’s stock is listed on NASDAQ under the symbol “UBFO”. United Security Bank (the “Bank”) is a wholly-owned bank subsidiary of the Company and was formed in 1987. United Security Bancshares Capital Trust I (the “Trust”) was formed during June of 2001 as a Delaware business trust for the sole purpose of issuing Trust Preferred securities. The Trust was originally formed as a subsidiary of the Company, but was deconsolidated during 2004 pursuant to the adoption of FIN 46 (as revised), “Consolidation of Variable Interest Entities”. During July 2007, the Trust Preferred Securities issued under USB Capital Trust I were redeemed, and upon retirement, the USB Capital Trust I was dissolved. During July the Company formed United Security Bancshares Capital Trust II and issued $15.0 million in Trust Preferred Securities with terms similar to those originally issued under USB Capital Trust I, except at a lower interest rate. At present, the Company does not engage in any material business activities other than ownership of the Bank.
United Security Bank
On June 12, 2001, the Bank became the wholly owned subsidiary of United Security Bancshares, through a tax-free holding company reorganization, accounted for on a basis similar to the pooling of interest method. In the transaction, each share of Bank stock was exchanged for a share of Company stock on a one-to-one basis.
The Bank is a California state-chartered bank headquartered in Fresno, California. It is also a member of the Federal Reserve System (“Fed member”). The Bank originally commenced business on December 21, 1987 as a national bank and, during the fourth quarter of 1998, filed an application with the California Department of Financial Institutions and other regulatory authorities to become a state-chartered bank. The shareholders approved the conversion in January of 1999, and the Bank was granted approval to operate as a state-chartered bank on February 3, 1999. The Bank’s operations are currently subject to federal and state laws applicable to state-chartered, Fed member banks and its deposits are insured up to the applicable limits by the Federal Deposit Insurance Corporation (the "FDIC"). The Bank is also subject to the Federal Deposit Insurance Act and regulatory reporting requirements of the FDIC. As a state-chartered bank and a member of the Federal Reserve System, the Bank is subject to supervision and regular examinations by the Board of Governors of the Federal Reserve System (the “FRB”) and the California Department of Financial Institutions (the “DFI”). In addition, the Bank is required to file reports with the FRB and provide such additional information as the FRB may require.
Effective August 25, 1995, the Bank consummated a merger with Golden Oak Bank, a two branch California state chartered bank located in Oakhurst, California, with assets of approximately $45 million at the date of merger. The merger was accounted for as a pooling of interests.
During February of 1997, the Bank completed the purchase of the deposits and certain assets of two branches of Wells Fargo Bank located in Caruthers and San Joaquin, both located in Fresno County. This brought the total branches operated at that time by the Bank to six and the total assets to approximately $190 million. The Bank paid a premium of approximately $1.2 million to purchase deposit accounts totaling approximately $33.4 million. The Bank also purchased cash balances as well as certain fixed assets of the branch operations.
During October of 1997, the Bank completed the purchase from Bank of America of two of its branches located in Firebaugh and Coalinga, both located in Fresno County. The acquisition brought the total branches operated by the Bank to eight at that time and the total assets to approximately $238 million. The premium paid by the Bank totaled approximately $3.0 million and the amount of deposits totaled approximately $44.4 million. The transaction included the receipt of cash balances of approximately $1.0 million and the purchase of premises and equipment totaling approximately $600,000.
USB Investment Trust Inc. was incorporated effective December 31, 2001 as a special purpose real estate investment trust (“REIT”) under Maryland law. The REIT is a subsidiary of the Bank and was funded with $133.0 million in real estate-secured loans contributed by the Bank. USB Investment Trust was originally formed to give the Bank flexibility in raising capital, and reduce the expenses associated with holding the assets contributed to USB Investment Trust. For further discussion of the REIT, refer to Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Income Taxes.
Effective April 23, 2004, the Company completed a merger with Taft National Bank headquartered in Taft, California. Taft National Bank (“Taft”) was merged into United Security Bank and Taft’s two branches operate as branches of United Security Bank. The total consideration paid to Taft shareholders was 241,447 shares of the Company’s Common Stock valued at just over $6 million. In the merger, the Company acquired $15.4 million in cash and short-term investments, $23.3 million in loans, and $48.2 million in deposits. This transaction was accounted for using the purchase method of accounting, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Taft based on the fair value of those assets and liabilities. The consolidated statement of income for the year ended December 31, 2004 includes the operations of Taft from the date of the acquisition to December 31, 2004.
On February 16, 2007, the Company completed its merger with Legacy Bank, N.A., located in Campbell, California, with the acquisition of 100 percent of Legacy’s outstanding common shares. At merger, Legacy Bank’s one branch was merged with and into United Security Bank, a wholly owned subsidiary of the Company. The total value of the merger transaction was $21.5 million, and the shareholders of Legacy Bank received merger consideration consisting of 976,411 shares of common stock of the Company. The merger transaction was accounted for as a purchase transaction, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Legacy Bank based on the fair value of those assets and liabilities. The net of assets acquired and liabilities assumed totaled approximately $8.6 million at the date of the merger. Fair value of Legacy assets and liabilities acquired, and resultant goodwill, has been determined and recorded as of the date of the merger and the resulting operations thereafter have been included in the financial statements as of and for the year ended December 31, 2007. (See Note 24 to the Company’s consolidated financial statements contained herein for details of the merger).
During November 2007, the Company purchased the recurring contractual revenue stream and certain fixed assets from ICG Financial, LLC. Additionally, the Company hired all but one of the former employees of ICG Financial, LLC and its subsidiaries. The total purchase price was $414,000 including $378,000 for the recurring revenue stream and $36,000 for the fixed assets. A newly formed department of the Bank, USB Financial Services provides wealth management, employee benefit, insurance and loan products, as well as consulting services for a variety of clients, utilizing employees hired from ICG Financial LLC. The Company believes the wealth management and related services provided by USB Financial Services will enhance the products and services offered by the Company, and increase noninterest income. The original capitalized cost of $378,000 for the recurring revenue stream is being amortized over a period of approximately three years. During the fourth quarter of 2008, the Company determined that the purchased intangible asset associated with recurring contractual revenue stream was impaired. As a result the Company recognized a $24,000 impairment loss on the purchased intangible asset, reducing the carrying value of the intangible asset to $206,000 at December 31, 2008.
At December 31, 2008, the Bank operates three branches (including its main office), one construction lending office, and one financial services office in Fresno and one branch each, in Oakhurst, Caruthers, San Joaquin, Firebaugh, Coalinga, Bakersfield, and Taft. In addition, the Company and Bank have administrative headquarters located at 2126 Inyo Street, Fresno, California, 93721.
At December 31, 2008, the consolidated Company had approximately $761.1 million in total assets, $533.7 million in net loans, $508.5 million in deposits, and $79.6 million in shareholders' equity.
The following discussion of the Company's services should be read in conjunction with "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
Bank Services
As a state-chartered commercial bank, United Security Bank offers a full range of commercial banking services primarily to the business and professional community and individuals located in Fresno, Madera, Kern, and Santa Clara Counties.
The Bank offers a wide range of deposit instruments including personal and business checking accounts and savings accounts, interest-bearing negotiable order of withdrawal ("NOW") accounts, money market accounts and time certificates of deposit. Most of the Bank's deposits are attracted from individuals and from small and medium-sized business-related sources.
The Bank also engages in a full complement of lending activities, including real estate mortgage, commercial and industrial, real estate construction, as well as agricultural, lease financing, and consumer loans, with particular emphasis on short and medium-term obligations. The Bank's loan portfolio is not concentrated in any one industry, although approximately 68% of the Bank's loans are secured by real estate. A loan may be secured (in whole or in part) by real estate even though the purpose of the loan is not to facilitate the purchase or development of real estate. At December 31, 2008, the Bank had loans (net of unearned fees) outstanding of $548.7 million, which represented approximately 108% of the Bank's total deposits and approximately 72% of its total assets.
Real estate mortgage loans are secured by deeds of trust primarily on commercial property. Repayment of real estate mortgage loans is generally from the cash flow of the borrower. Commercial and industrial loans have a high degree of industry diversification. Loans may be originated in the Company’s market area, or participated with other financial institutions outside the Company’s market area. A substantial portion of commercial and industrial loans are secured by accounts receivable, inventory, leases or other collateral. The remainder are unsecured; however extensions of credit are predicated on the financial capacity of the borrower to repay the extension of credit. Repayment of commercial loans is generally from the cash flow of the borrower. Real estate construction loans consist of loans to residential contractors, which are secured by single-family residential properties. All real estate loans have established equity requirements. Repayment of real estate construction loans is generally from long-term mortgages with other lending institutions. Agricultural loans are generally secured by land, equipment, inventory and receivables. Repayment of agricultural loans is from the expected cash flow of the borrower.
In the normal course of business, the Bank makes various loan commitments and incurs certain contingent liabilities. At December 31, 2008 and 2007, loan commitments of the Bank $112.3 million and $196.3 million, respectively, and letters of credit totaled $7.1 million and $6.7 million, respectively. Of the $112.3 million in loan commitments outstanding at December 31, 2008, $84.6 million or 75.6% were for loans with maturities of one year or less. Due to the nature of the business of the Bank's customers, there are no seasonal patterns or absolute predictability to the utilization of unused loan commitments; therefore the Bank is unable to forecast the extent to which these commitments will be exercised within the current year. The Bank does not believe that any such utilization will constitute a material liquidity demand. The Company does however have collateralized and uncollateralized lines of credit which could be utilized if such loan commitments were to be exercised in excess of normal expectations.
In addition to the loan and deposit services discussed above, the Bank also offers a wide range of specialized services designed to attract and service the needs of commercial customers and account holders. These services include online banking, safe deposit boxes, ATM services, payroll direct deposit, cashier's checks, traveler's checks, money orders, and foreign drafts. In addition, the Bank offers a variety of specialized financial services, including wealth management, employee benefit, insurance and loan products, as well as consulting services for a variety of clients. The Bank does not operate a trust department; however, it makes arrangements with its correspondent bank to offer trust services to its customers on request. Most of the Bank's business originates within Fresno, Madera, Kern, and Santa Clara Counties. Neither the Bank’s business or liquidity is seasonal, and there has been no material effect upon the Bank's capital expenditures, earnings or competitive position as a result of federal, state or local environmental regulation.
Competition and Market Share
The banking business in California generally, and in the market area served by the Company specifically, is highly competitive with respect to both loans and deposits. The Company competes for loans and deposits with other commercial banks, savings and loan associations, finance companies, money market funds, credit unions and other financial institutions, including a number that are substantially larger than the Company. Deregulation of the banking industry, increased competition from non-bank entities for the cash balances of individuals and businesses, and continuing developments in the computer and communications industries have had, and most likely will continue to have, a significant impact on the Company's competitive position. With the enactment of interstate banking legislation in California, bank holding companies headquartered outside of California will continue to enter the California market and provide competition for the Company. Additionally, with the Gramm-Leach-Bliley Act of 1999, traditional competitive barriers between insurance companies, securities underwriters, and commercial banks have been eased, allowing a greater number of financial intermediaries to offer a wider assortment of financial services. Many of the major commercial banks operating in the Company's market areas offer certain services such as trust and international banking services, which the Company does not offer directly. In addition, banks with larger capitalization have larger lending limits and are thereby able to serve larger customers.
The Company’s primary market area at December 31, 2008 was located in Fresno, Madera, and Kern Counties, in which approximately 34 FDIC-insured financial institutions compete for business. Santa Clara County was added during February 2007 with the Legacy Bank acquisition, in which approximately 75 FDIC-insured financial institutions compete for business. The following table sets forth information regarding deposit market share and ranking by county as of June 30, 2008, which is the most current information available.
| | | | | | |
| | | | | 4.70 | % |
| | | | | 3.91 | % |
| | | | | 1.26 | % |
Total of Fresno, Madera, Kern Counties | | | | | 3.43 | % |
| | | | | 0.07 | % |
Supervision and Regulation
The Company
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956, as amended (the “BHC Act”), and is registered as such with the FRB. A bank holding company is required to file with the FRB annual reports and other information regarding its business operations and those of its subsidiaries and is also subject to examination by the FRB.
The BHC Act requires, among other things, prior approval before acquiring, directly or indirectly, ownership or control of any voting shares of any bank, if after such acquisition it would directly or indirectly own or control more than 5% of the voting stock of that bank, unless it already owns a majority of the voting stock of that bank. The BHC Act also provides that the FRB shall not approve any acquisition that would result in or further the creation of a monopoly, or the effect of which may be substantially to lessen competition, unless the anticompetitive effects of the proposed transaction are clearly outweighed by the probable effect in meeting the convenience and needs of the community served.
Furthermore, under the BHC Act, a bank holding company is, with limited exceptions, prohibited from (i) acquiring direct or indirect ownership or control of more than 5% of the voting shares of any company which is not a bank or (ii) engaging in any activity other than managing or controlling banks. With the prior approval of the FRB, however, a bank holding company may own shares of a company engaged in activities which the FRB has determined to be so closely related to banking or managing or controlling banks as to be proper incident thereto.
The BHC Act requires a bank holding company to serve as a source of financial and managerial strength to its subsidiary banks. It is the FRB’s policy that a bank holding company should stand ready to use available resources to provide adequate capital funds to subsidiary banks during periods of financial stress and should maintain the financial flexibility and capital raising capacity to obtain additional resources for assisting a subsidiary bank. Under certain conditions, the FRB may conclude that certain actions of a bank holding company, such as payment of cash dividends, would constitute unsafe and unsound banking practices because they violate the FRB’s “source of strength” doctrine.
A bank holding company and its subsidiaries are prohibited from certain tie-in arrangements in connection with any extension of credit, sale or lease of property or furnishing of services. For example, with certain exceptions, a bank may not condition an extension of credit on a promise by its customer to obtain other services by it, its holding company or other subsidiaries, or on a promise by its customer not to obtain services from a competitor. In addition, federal law imposes certain restrictions between the Company and its subsidiaries, including the Bank. As an affiliate of the Bank, the Company is subject, with certain exceptions, to provisions of federal law imposing limitations on, and requiring collateral for, extensions of credit by the Bank to its affiliates.
In 1999 the Gramm-Leach-Bliley Act (the “GLBA”) was enacted. The GLBA became effective in March of 2000 and is a financial services modernization law that, among other things, facilitates broad new affiliations among securities firms, insurance companies and bank holding companies by repealing the 66-year old provisions of the Glass-Steagall Act. The GLBA allows the formation of financial holding companies (“FHC’s”), which are bank holding companies with substantially expanded powers. A bank holding company must acquire the approval of the FRB to become a FHC. Under these expanded powers, affiliations may occur between bank holding companies, securities firms and insurance companies, subject to a blend of umbrella supervision and regulation of the newly formed consolidated entity by the Federal Reserve, oversight of the FHC’s bank and thrift subsidiaries by their primary federal and state banking regulators and financial regulation of the FHC’s nonbank subsidiaries by their respective specialized regulators. The Company has not applied to become a FHC.
As a public company, United Security Bancshares is subject to the Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act amends the Securities and Exchange Act of 1934, and is intended to protect investors by, among other things, improving the reliability of financial reporting, increasing management accountability, and increasing the independence of Directors and the Company’s external accountants.
The Company is subject to the periodic reporting requirements of the Securities Exchange Act of 1934, as amended, which include but are not limited to the filing of annual, quarterly and other current reports with the SEC.
The Bank
The Bank as a state-chartered bank is subject to regulation, supervision and regular examination by the California Department of Financial Institutions. In addition, The Bank is also a member of the Federal Reserve System and, as such, is subject to applicable provisions of the Federal Reserve Act and regulations issued thereunder and, is subject to regulation, supervision and regular examination by the Federal Reserve Bank. The Bank is subject to California law, insofar as they are not preempted by federal banking law. Deposits of the Bank are insured by the FDIC up to the applicable limits in an amount up to $250,000 per customer, and, as such, the Bank is subject to the regulations of the FDIC and the Federal Deposit Insurance Act. As a consequence of the extensive regulation of commercial banking activities in California and the United States, the Bank’s business is particularly susceptible to changes in California and federal legislation and regulation, which may have the effect of increasing the cost of doing business, limiting permissible activities or increasing competition.
The Bank is a member of the Federal Home Loan Bank of San Francisco (the “FHLB-SF”). Among other benefits, each Federal Home Loan Bank (“FHLB”) serves as a reserve or central bank for its members within its assigned region. Each FHLB is financed primarily from the sale of consolidated obligations of the FHLB system. Each FHLB makes available loans or advances to its members in compliance with the policies and procedures established by the Board of Directors of the individual FHLB. . The FHLB-SF utilizes a single class of stock with a par value of $100 per share, which may be issued, exchanged, redeemed and repurchased only at par value. As an FHLB member, the Bank is required to own FHLB –SF capital stock in an amount equal to the greater of:
| | § | a membership stock requirement with an initial cap of $25 million (100% of “membership asset value” as defined), or |
| | § | an activity based stock requirement (based on percentage of outstanding advances). |
The FHLB – SF capital stock is redeemable on five years written notice, subject to certain conditions. At December 31, 2008 the Bank owned 41,595 shares of the FHLB-SF capital stock.
The FRB requires all depository institutions to maintain non-interest bearing reserves at specified levels against their transaction accounts and non-personal time deposits. At December 31, 2008, we were in compliance with these requirements.
Various other requirements and restrictions under the laws of the United States and the State of California affect the operations of the Bank. Federal and California statutes and regulations relate to many aspects of the Bank’s operations, including capital requirements and disclosure requirements to depositors and borrowers, requirements to maintain reserves against deposits, limitations on interest rates payable on deposits, loans, investments, and restrictions on borrowings and on payment of dividends. The DFI regulates the number and location of branch offices of a state-chartered bank, and may permit a bank to maintain branches only to the extent allowable under state law for state banks. California law presently permits a bank to locate a branch in any locality in the state. Additionally, California law exempts banks from California usury laws.
Effect of Governmental Policies and Recent Legislation
Banking has traditionally been a business that depends on rate differentials. In general, the difference between the interest rate paid by the Company on its deposits and other borrowings and the interest rate received on loans extended to its customers and securities held in the Company's portfolio comprise the major portion of the Company's earnings. These rates are highly sensitive to many factors which are beyond the control of the Company. Accordingly, the earnings and growth of the Company are subject to the influence of domestic and foreign economic conditions, including, but not limited to, inflation, recession and unemployment.
The earnings and growth of the Company are affected not only by general economic conditions, both domestic and foreign, but also by the monetary and fiscal policies of the United States government and its agencies, particularly the Federal Reserve Board (“FRB”). The FRB implements national monetary policies (with objectives such as to curb inflation and combat recession) by its open market operations in United States Government securities, by adjusting the required level of reserves for financial institutions subject to reserve requirements, and by varying the discount rates applicable to borrowing by banks which are members of the Federal Reserve System. The actions of the FRB in these areas influence the growth of bank loans, investments and deposits and also affect interest rates charged on loans and paid on deposits. The FRB’s policies have had a significant effect on the operating results of commercial banks and are expected to continue to do so in the future. The nature and timing of any future changes in monetary policies are not predictable. In addition, adverse economic conditions could make a higher provision for loan losses a prudent course and could cause higher loan charge-offs, thus adversely affecting the Company’s net income.
The deposit insurance fund or DIF of the FDIC insures our customer deposits up to prescribed limits for each depositor. The Federal Deposit Insurance Reform Act of 2005 and the Federal Deposit Insurance Reform Conforming Amendments Act of 2005 amended the insurance of deposits by the FDIC and collection of assessments from insured depository institutions for deposit insurance. The FDIC approved a final rule to determine risk-based assessment rates on November 2, 2006, with rates effective on January 1, 2007, however a new rules were proposed in 2008. An insured depository institution’s assessment rate under the final rule is based on the new assessment rate schedule, its long-term debt issuer ratings or recent financial ratios and supervisory ratings. The proposed rule would also look at other factors that increase risks to the FDIC’s insurance fund. Any increase in assessments or the assessment rate could have a material adverse effect on our business, financial condition, results of operations or cash flows, depending on the amount of the increase. Furthermore, the FDIC is authorized to raise insurance premiums under certain circumstances.
The FDIC is authorized to terminate a depository institution’s deposit insurance upon a finding by the FDIC that the institution’s financial condition is unsafe or unsound or that the institution has engaged in unsafe or unsound practices or has violated any applicable rule, regulation, order or condition enacted or imposed by the institution’s regulatory agency. The termination of deposit insurance for the bank would have a material adverse effect on our business, financial condition, results of operations or cash flows.
The Federal Reserve Act and FRB Regulation O place limitations and conditions on loans or extensions of credit to:
| | § | a bank’s or bank holding company’s executive officers, directors and principal shareholders (i.e., in most cases, those persons who own, control or have power to vote more than 10% of any class of voting securities), |
| | § | any company controlled by any such executive officer, director or shareholder, or |
| | § | any political or campaign committee controlled by such executive officer, director or principal shareholder. |
Loans and leases extended to any of the above persons must comply with loan-to-one-borrower limits, require prior full board approval when aggregate extensions of credit to the person exceed specified amounts, must be made on substantially the same terms (including interest rates and collateral) as, and follow credit-underwriting procedures that are not less stringent than, those prevailing at the time for comparable transactions with non-insiders, and must not involve more than the normal risk of repayment or present other unfavorable features. In addition, Regulation O provides that the aggregate limit on extensions of credit to all insiders of a bank as a group cannot exceed the bank’s unimpaired capital and unimpaired surplus. Regulation O also prohibits a bank from paying an overdraft on an account of an executive officer or director, except pursuant to a written pre-authorized interest-bearing extension of credit plan that specifies a method of repayment or a written pre-authorized transfer of funds from another account of the officer or director at the bank.
From time to time, legislation is enacted which has the effect of increasing the cost of doing business, limiting or expanding permissible activities or affecting the competitive balance between banks and other financial institutions. Proposals to change the laws and regulations governing the operations and taxation of banks and other financial institutions are frequently made in Congress, in the California legislature and before various bank regulatory agencies. The likelihood of any major change and the impact such change may have on the Company is impossible to predict. Certain of the potentially significant changes which have been enacted recently and other which are currently under consideration by Congress or various regulatory agencies or professional agencies are discussed below.
Recent Legislation and Other Changes
Federal and state laws affecting banking are enacted from time to time, and similarly federal and state regulations affecting banking are also adopted from time to time. The following include some of the recent laws and regulations affecting banking.
On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted to provide stimulus to the struggling US economy. ARRA authorizes spending of $787 billion, including about $288 billion for tax relief, $144 billion for state and local relief aid, and $111 billion for infrastructure and science. In addition, ARRA includes additional executive compensation restrictions for recipients of funds from the US Treasury under the Troubled Assets Relief Program of the Emergency Economic Stimulus Act of 2008 (“EESA”). The provisions of EESA amended by the ARRA include (i) expanding the coverage of the executive compensation limits to as many as the 25 most highly compensated employees of a TARP funds recipient and its affiliates for certain aspects of executive compensation limits and (ii) specifically limiting incentive compensation of covered executives to one-third of their annual compensation which is required to be paid in restricted stock that does not vest until all of the TARP funds are no longer outstanding (note that if TARP warrants remain outstanding and no other TARP instruments are outstanding, then such warrants would not be considered outstanding for purposes of this incentive compensation restriction. In addition, the board of directors of any TARP recipient is required under EESA, as amended to have a company-wide policy regarding excessive or luxury expenditures, as identified by the Treasury, which may include excessive expenditures on entertainment or events; office and facility renovations; aviation or other transportation services; or other activities or events that are not reasonable expenditures for staff development, reasonable performance incentives, or other similar measures conducted in the normal course of the business operations of the TARP recipient.
EESA, as amended by ARRA, provides for a new incentive compensation restriction for financial institutions receiving TARP funds. The number of executives and employees covered by this new incentive compensation restriction depends on the amount of TARP funds received by such entity. For community banks that have or will receive less than $25 million, the new incentive compensation restriction applies only to the highest paid employee. This new incentive compensation restriction prohibits a TARP recipient from paying or accruing any bonus, retention award, or incentive compensation during the period in which any TARP obligation remains outstanding, except that such prohibition shall not apply to the payment of long-term restricted stock by such TARP recipient, provided that such long-term restricted stock (i) does not fully vest during the period in which any TARP obligation remains outstanding, (ii) has a value in an amount that is not greater than 1/3 of the total amount of annual compensation of the employee receiving the stock; and (iii) is subject to such other terms and conditions as the Secretary of the Treasury may determine is in the public interest. In addition, this prohibition does not prohibit any bonus payment required to be paid pursuant to a written employment contract executed on or before February 11, 2009, as such valid employment contracts are determined by the Treasury.
EESA was amended by ARRA to also provide additional corporate governance provisions with respect to executive compensation including the following:
| | · | ESTABLISHMENT OF STANDARDS - During the period in which any TARP obligation remains outstanding, each TARP recipient shall be subject to the standards in the regulations issued by the Treasury with respect to executive compensation limitations for TARP recipients, and the provisions of section 162(m)(5) of the Internal Revenue Code of 1986, as applicable (nondeductibility of executive compensation in excess of $500,000). |
| | · | COMPLIANCE WITH STANDARDS - The Treasury is required to see that each TARP recipient meet the required standards for executive compensation and corporate governance. |
| | · | SPECIFIC REQUIREMENTS FOR THE REQUIRED STANDARDS - - |
| | § | Limits on compensation that exclude incentives for senior executive officers of the TARP recipient to take unnecessary and excessive risks that threaten the value of the financial institution during the period in which any TARP obligation remains outstanding. |
| | § | A clawback requirement by such TARP recipient of any bonus, retention award, or incentive compensation paid to a senior executive officer and any of the next 20 most highly-compensated employees of the TARP recipient based on statements of earnings, revenues, gains, or other criteria that are later found to be materially inaccurate. |
| | § | A prohibition on such TARP recipient making any golden parachute payment to a senior executive officer or any of the next 5 most highly-compensated employees of the TARP recipient during the period in which any TARP obligation remains outstanding. |
| | § | A prohibition on any compensation plan that would encourage manipulation of the reported earnings of such TARP recipient to enhance the compensation of any of its employees. |
| | § | A requirement for the establishment of an independent Compensation Committee that meets at least twice a year to discuss and evaluate employee compensation plans in light of an assessment of any risk posed to the TARP recipient from such plans. For a non SEC company that is a TARP recipient that has received $25,000,000 or less of TARP assistance, the duties of the compensation committee may be carried out by the board of directors of such TARP recipient. |
In addition, EESA as amended by ARRA provides that for any TARP recipient, its annual meeting materials shall include a nonbinding shareholder approval proposal of executive compensation for shareholders to vote. The SEC is to establish regulations to implement this provision. While nonpublic companies are required to include this proposal, it is not known what the regulations will provide as to executive compensation disclosure requirements of such TARP recipients, and whether they will be as extensive as the existing SEC executive compensation requirements. In addition, shareholders are allowed to present other nonbinding proposals with respect to executive compensation.
On February 10, 2009, the U. S. Treasury, the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision are announced a comprehensive set of measures to restore confidence in the strength of U.S. financial institutions and restart the critical flow of credit to households and businesses. This program is intended to restore the flows of credit necessary to support recovery.
The core program elements include:
| | · | A new Capital Assistance Program to help ensure that our banking institutions have sufficient capital to withstand the challenges ahead, paired with a supervisory process to produce a more consistent and forward-looking assessment of the risks on banks' balance sheets and their potential capital needs. |
| | · | A new Public-Private Investment Fund on an initial scale of up to $500 billion, with the potential to expand up to $1 trillion, to catalyze the removal of legacy assets from the balance sheets of financial institutions. This fund will combine public and private capital with government financing to help free up capital to support new lending. |
| | · | A new Treasury and Federal Reserve initiative to dramatically expand – up to $1 trillion – the existing Term Asset-Backed Securities Lending Facility (TALF) in order to reduce credit spreads and restart the securitized credit markets that in recent years supported a substantial portion of lending to households, students, small businesses, and others. |
| | · | An extension of the FDIC's Temporary Liquidity Guarantee Program to October 31, 2009. A new framework of governance and oversight to help ensure that banks receiving funds are held responsible for appropriate use of those funds through stronger conditions on lending, dividends and executive compensation along with enhanced reporting to the public. |
In October 2008, the President signed the Emergency Economic Stabilization Act of 2008 (“EESA”), commonly referred to as the bailout bill in response to the global financial crisis of 2008 authorizing the United States Secretary of the Treasury with authority to spend up to US$700 billion to purchase distressed assets, especially mortgage-backed securities, under the Troubled Assets Relief Program (“TARP”) and make capital injections into banks under the Capital Purchase Program. EESA gives the government the unprecedented authority to buy troubled assets on balance sheets of financial institutions under the Troubled Assets Relief Program and increases the limit on insured deposits from $100,000 to $250,000 until December 1, 2009. Some of the other provisions of EESA are as follows:
| | · | accelerated from 2011 to 2008 the date that the Federal Reserve Bank could pay interest on deposits of banks held with the Federal Reserve to meet reserve requirements; |
| | · | to the extent that the U. S. Treasury purchases mortgage securities as part of TARP, the Treasury shall implement a plan to minimize foreclosures including using guarantees and credit enhancements to support reasonable loan modifications, and to the extent loans are owned by the government to consent to the reasonable modification of such loans; |
| | · | limits executive compensation for executives for TARP participating financial institutions including a maximum corporate tax deduction limit of $500,000 for each of the top five highest paid executives of such institution, requiring clawbacks of incentive compensation that were paid based on inaccurate or false information, limiting golden parachutes for involuntary and certain voluntary terminations to 2.99x their average annual salary and bonus for the last five years, and prohibiting the payment of incentive compensation that encourages management to take unnecessary and excessive risks with respect to the institution; |
| | · | extends the mortgage debt forgiveness provision of the Mortgage Forgiveness Debt Relief Act of 2007 by three years (2012) to ease the income tax burden on those involved with certain foreclosures; and |
| | · | qualified financial institutions may count losses on FNMA and FHLMC preferred stock against ordinary income, rather than capital gain income. |
The Temporary Liquidity Guarantee Program was implemented by the FDIC on October 14, 2008 to mitigate the lack of liquidity in the financial markets. The Temporary Liquidity Guarantee Program has two primary components: the Debt Guarantee Program, by which the FDIC will guarantee the payment of certain newly-issued senior unsecured debt, and the Transaction Account Guarantee Program, by which the FDIC will guarantee certain noninterest-bearing transaction accounts. The Debt Guarantee Program provides for an FDIC guarantee as to the payment of all senior unsecured debt (with a term of more than 30 days) issued by a qualified participating entity (insured depository institutions, bank and financial holding companies, and certain savings and loan holding companies) up to a limit of 125 percent of all senior unsecured debt outstanding on September 30, 2008, and maturing by June 30, 2009. The FDIC guarantee is until June 30, 2012, and the fee for such guarantee depends on the term with a maximum of 100 basis points for terms in excess of 365 days. The Transaction Account Guarantee Program is the second part of the FDIC’s Temporary Liquidity Guarantee Program. The FDIC provides for a temporary full guarantee held at a participating FDIC-insured depository institution of noninterest-bearing transaction accounts above the existing deposit insurance limit at the additional cost of 10 basis points per annum. ��This coverage became effective on October 14, 2008, and would continue through December 31, 2009.
On July 30, 2008, the Housing and Economic Recovery Act was was signed by President Bush. It authorizes the Federal Housing Administration to guarantee up to $300 billion in new 30-year fixed rate mortgages for subprime borrowers if lenders write-down principal loan balances to 90 percent of current appraisal value. It is also intended to restore confidence in Fannie Mae and Freddie Mac by strengthening regulations and injecting capital into them. States will be authorized to refinance subprime loans using mortgage revenue bonds. It also establishes the Federal Housing Finance Agency (FHFA) out of the Federal Housing Finance Board (FHFB) and Office of Federal Housing Enterprise Oversight (OFHEO).
In 2008, the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision amended their regulatory capital rules to permit banks, bank holding companies, and savings associations (as to any of these a “financial institution”) to reduce the amount of goodwill that a banking organization must deduct from tier 1 capital by the amount of any deferred tax liability associated with that goodwill. However, a financial institution that reduces the amount of goodwill deducted from tier 1 capital by the amount of the deferred tax liability is not permitted to net this deferred tax liability against deferred tax assets when determining regulatory capital limitations on deferred tax assets. For these financial institutions, the amount of goodwill deducted from tier 1 capital will reflect each institution’s maximum exposure to loss in the event that the entire amount of goodwill is impaired or derecognized, an event which triggers the concurrent derecognition of the related deferred tax liability for financial reporting purposes.
On October 7, 2008 the FDIC adopted a restoration plan that would increase the rates banks pay for deposit insurance, and proposed rules for adjusting the system that determines what deposit insurance premium rate a bank pays the FDIC. Currently, banks pay anywhere from five basis points to 43 basis points for deposit insurance. Under the proposal rule, the assessment rate schedule would be raised uniformly by 7 basis points (annualized) beginning on January 1, 2009. Beginning with the second quarter of 2009, changes would be made to the deposit insurance assessment system to make the increase in assessments fairer by requiring riskier institutions to pay a larger share. Together, the proposed changes would improve the way the system differentiates risk among insured institutions and help ensure that the reserve ratio returns to at least 1.15 percent by the end of 2013. The proposed changes to the assessment system include assessing higher rates to institutions with a significant reliance on secured liabilities, which generally raises the FDIC's loss in the event of failure without providing additional assessment revenue. The proposal also would assess higher rates for institutions with a significant reliance on brokered deposits but, for well-managed and well-capitalized institutions, only when accompanied by rapid asset growth. Brokered deposits combined with rapid asset growth have played a role in a number of costly failures, including some recent ones. The proposal also would provide incentives in the form of a reduction in assessment rates for institutions to hold long-term unsecured debt and, for smaller institutions, high levels of Tier 1 capital. The FDIC also voted to maintain the Designated Reserve Ratio at 1.25 percent as a signal of its long term target for the fund.
The Federal Reserve Board in October 2008 approved final amendments to Regulation C that revise the rules for reporting price information on higher-priced mortgage loans. The changes are intended to improve the accuracy and usefulness of data reported under the Home Mortgage Disclosure Act. Regulation C currently requires lenders to collect and report the spread between the annual percentage rate (APR) on a mortgage loan and the yield on a Treasury security of comparable maturity if the spread is greater than 3.0 percentage points for a first lien loan or greater than 5.0 percentage points for a subordinate lien loan. This difference is known as a rate spread. Under the final rule, a lender will report the spread between the loan's APR and a survey-based estimate of APRs currently offered on prime mortgages of a comparable type ("average prime offer rate") if the spread is equal to or greater than 1.5 percentage points for a first lien loan or equal to or greater than 3.5 percentage points for a subordinate-lien loan. The Board will publish average prime offer rates based on the Primary Mortgage Market Survey® currently published by Freddie Mac. In setting the rate spread reporting threshold, the Board sought to cover subprime mortgages and generally avoid covering prime mortgages. The changes to Regulation C conform the threshold for rate spread reporting to the definition of higher-priced mortgage loans adopted by the Board under Regulation Z (Truth in Lending) in July of 2008.
The Federal Reserve Board in July 2008 approved a final rule for home mortgage loans to better protect consumers and facilitate responsible lending. The rule prohibits unfair, abusive or deceptive home mortgage lending practices and restricts certain other mortgage practices. The final rule also establishes advertising standards and requires certain mortgage disclosures to be given to consumers earlier in the transaction. The final rule, which amends Regulation Z (Truth in Lending) and was adopted under the Home Ownership and Equity Protection Act (HOEPA), largely follows a proposal released by the Board in December 2007, with enhancements that address ensuing public comments, consumer testing, and further analysis.
The final rule adds four key protections for a newly defined category of "higher-priced mortgage loans" secured by a consumer's principal dwelling. For loans in this category, these protections will:
| | · | Prohibit a lender from making a loan without regard to borrowers' ability to repay the loan from income and assets other than the home's value. A lender complies, in part, by assessing repayment ability based on the highest scheduled payment in the first seven years of the loan. To show that a lender violated this prohibition, a borrower does not need to demonstrate that it is part of a "pattern or practice." |
| | · | Require creditors to verify the income and assets they rely upon to determine repayment ability. |
| | · | Ban any prepayment penalty if the payment can change in the initial four years. For other higher-priced loans, a prepayment penalty period cannot last for more than two years. |
| | · | Require creditors to establish escrow accounts for property taxes and homeowner's insurance for all first-lien mortgage loans. |
In addition to the rules governing higher-priced loans, the rules adopt the following protections for loans secured by a consumer's principal dwelling, regardless of whether the loan is higher-priced:
| | · | Creditors and mortgage brokers are prohibited from coercing a real estate appraiser to misstate a home's value. |
| | · | Companies that service mortgage loans are prohibited from engaging in certain practices, such as pyramiding late fees. In addition, servicers are required to credit consumers' loan payments as of the date of receipt and provide a payoff statement within a reasonable time of request. |
| | · | Creditors must provide a good faith estimate of the loan costs, including a schedule of payments, within three days after a consumer applies for any mortgage loan secured by a consumer's principal dwelling, such as a home improvement loan or a loan to refinance an existing loan. Currently, early cost estimates are only required for home-purchase loans. Consumers cannot be charged any fee until after they receive the early disclosures, except a reasonable fee for obtaining the consumer's credit history. |
For all mortgages, the rule also sets additional advertising standards. Advertising rules now require additional information about rates, monthly payments, and other loan features. The final rule bans seven deceptive or misleading advertising practices, including representing that a rate or payment is "fixed" when it can change.
The rule's definition of "higher-priced mortgage loans" will capture virtually all loans in the subprime market, but generally exclude loans in the prime market. To provide an index, the Federal Reserve Board will publish the "average prime offer rate," based on a survey currently published by Freddie Mac. A loan is higher-priced if it is a first-lien mortgage and has an annual percentage rate that is 1.5 percentage points or more above this index, or 3.5 percentage points if it is a subordinate-lien mortgage. The new rules take effect on October 1, 2009. The single exception is the escrow requirement, which will be phased in during 2010 to allow lenders to establish new systems as needed.
In May 2008, the Federal Reserve Board proposed rules to prohibit unfair practices regarding credit cards and overdraft services that would, among other provisions, protect consumers from unexpected increases in the rate charged on pre-existing credit card balances. The rules, proposed for public comment under the Federal Trade Commission Act (FTC Act), also would forbid banks from imposing interest charges using the "two-cycle" billing method, would require that consumers receive a reasonable amount of time to make their credit card payments, and would prohibit the use of payment allocation methods that unfairly maximize interest charges. They also include protections for consumers that use overdraft services offered by their bank. The proposed changes to the Board’s Regulation AA (Unfair or Deceptive Acts or Practices) would be complemented by separate proposals that the Board is issuing under the Truth in Lending Act (Regulation Z) and the Truth in Savings Act (Regulation DD).
The provisions addressing credit card practices are part of the Board’s ongoing effort to enhance protections for consumers who use credit cards, and follow the Board's 2007 proposal to improve the credit card disclosures under the Truth in Lending Act. The FTC Act proposal includes five key protections for consumers that use credit cards:
| | · | Banks would be prohibited from increasing the rate on a pre-existing credit card balance (except under limited circumstances) and must allow the consumer to pay off that balance over a reasonable period of time. |
| | · | Banks would be prohibited from applying payments in excess of the minimum in a manner that maximizes interest charges. |
| | · | Banks would be required to give consumers the full benefit of discounted promotional rates on credit cards by applying payments in excess of the minimum to any higher-rate balances first, and by providing a grace period for purchases where the consumer is otherwise eligible. |
| | · | Banks would be prohibited from imposing interest charges using the "two-cycle" method, which computes interest on balances on days in billing cycles preceding the most recent billing cycle. |
| | · | Banks would be required to provide consumers a reasonable amount of time to make payments. |
The proposal would also address subprime credit cards by limiting the fees that reduce the available credit. In addition, banks that make firm offers of credit advertising multiple rates or credit limits would be required to disclose in the solicitation the factors that determine whether a consumer will qualify for the lowest rate and highest credit limit. The Board's proposal under the FTC Act also addresses acts or practices in connection with a bank’s payment of overdrafts on a deposit account, whether the overdraft is created by check, a withdrawal at an automated teller machine, a debit card purchase, or other transactions. The proposal requires institutions to provide consumers with notice and an opportunity to opt out of the payment of overdrafts, before any overdraft fees or charges may be imposed on consumers' accounts.
In December 2007, the FDIC issued a proposed rule to improve the process for determining uninsured depositors at larger institutions in the event of a failure. The measure is intended to allow the FDIC to make funds promptly available to insured deposit customers in the unlikely event that a large financial institution is closed. The proposal is broken into two parts. One section relates to so-called covered institutions, those that have at least $2 billion in domestic deposits, have more than 250,000 deposit accounts, or have total assets of more than $20 billion, regardless of the number of deposits or accounts. A covered institution would be required to adopt mechanisms that, in the event of a failure, would place provisional holds on large deposit accounts in a percentage specified by the FDIC; provide the FDIC with deposit account data in a standard format; and allow automatic removal of provisional holds once the FDIC makes an insurance determination. The second part applies to all FDIC-insured institutions, regardless of size, and governs the specific time and circumstance under which account balances will be determined in the event of a failure. The FDIC is proposing to use the end-of-day ledger balance as normally calculated by the institution. By using the end-of-day ledger, the FDIC will be able to apply a single standard across all failed banks in order to treat every transaction equally. This is also the same deposit balance used for Call Report and assessment purposes. There would be no requirements placed on open institutions as a result of this provision. The FDIC places a high priority on providing access to insured deposits promptly and, in the past, has usually been able to allow most depositors access to their deposits on the next business day. If adopted, the proposed rule would better enable the FDIC to continue this practice, especially for the larger, more complex institutions it insures.
The Federal Reserve Board in November 2007 approved final rules to implement the Basel II framework for large bank capital requirements. The new risk-based capital requirements apply to large, internationally active banking organizations in the United States. The new capital adequacy requirements were designed to align regulatory capital requirements with actual risks and are expected to strengthen banking organizations’ risk-management practices. Basel II would replace the current U.S. rules implementing the Basel Capital Accord of 1988 (Basel I) and be mandatory for large, internationally active banking organizations (so-called “core” banking organizations with at least $250 billion in total assets or at least $10 billion in foreign exposure) and optional for others. Under Basel II, core banking organizations would be required to enhance the measurement and management of their risks, including credit risk and operational risk. Core banking organizations will be required to have rigorous processes for assessing their overall capital adequacy in relation to their total risk profile and to publicly disclose information about their risk profile and capital adequacy.
The new U.S. Basel II rule is technically consistent in most respects with international approaches and includes a number of prudential safeguards as originally proposed in September 2006. These safeguards include a requirement that banking organizations satisfactorily complete a four-quarter parallel run period before operating under the Basel II framework, a requirement that an institution satisfactorily complete a series of transitional periods before operating under Basel II without floors, and a commitment by the agencies to conduct ongoing analysis of the framework to ensure Basel II is working as intended. Basel II in the United States will be implemented with retention of the leverage ratio and prompt corrective action (PCA) requirements, which will continue to bolster capital and complement risk-based measures. Following a successful parallel run period, a banking organization would have to progress through three transitional periods (each lasting at least one year), during which there would be floors on potential declines in risk-based capital requirements. Those transitional floors would limit maximum cumulative reductions of a banking organization’s risk-based capital requirements to 5 percent during the first transitional floor period, 10 percent during the second transitional floor period, and 15 percent during the third transitional floor period. A banking organization would need approval from its primary federal regulator to move into each of the transitional floor periods, and at the end of the third transitional floor period to move to full Basel II.
In September 2007, the SEC and Federal Reserve Board of Governors adopted final rules to implement the bank “broker” provisions of the Gramm-Leach-Bliley Act. The rules define the scope of securities activities that banks may conduct without registering with the SEC as a securities broker and implement the most important “broker” exceptions for banks adopted by the GLB Act. Specifically, the rules implement the statutory exceptions that allow a bank, subject to certain conditions, to continue to conduct securities transactions for its customers as part of the bank’s trust and fiduciary, custodial and deposit “sweep” functions, and to refer customers to a securities broker-dealer pursuant to a networking arrangement with the broker-dealer. The rules are designed to accommodate the business practices of banks and to protect investors. The effective date for compliance is the first day of the bank’s fiscal year commencing after September 30, 2008.
The federal financial regulatory agencies in December 2006 issued a new interagency policy statement on the allowance for loan and lease losses (ALLL) along with supplemental frequently asked questions. The policy statement revises and replaces a 1993 policy statement on the ALLL. The agencies issued the revised policy statement in view of today’s uncertain economic environment and the presence of concentrations in untested loan products in the loan portfolios of insured depository institutions. The policy statement has also been revised to conform with generally accepted accounting principles (GAAP) and post-1993 supervisory guidance. The 1993 policy statement described the responsibilities of the boards of directors, management, and banking examiners regarding the ALLL; factors to be considered in the estimation of the ALLL; and the objectives and elements of an effective loan review system, including a sound credit grading system. The policy statement reiterates that each institution has a responsibility for developing, maintaining and documenting a comprehensive, systematic, and consistently applied process appropriate to its size and the nature, scope, and risk of its lending activities for determining the amounts of the ALLL and the provision for loan and lease losses and states that each institution should ensure controls are in place to consistently determine the ALLL in accordance with GAAP, the institution’s stated policies and procedures, management’s best judgment and relevant supervisory guidance.
The policy statement also restates that insured depository institutions must maintain an ALLL at a level that is appropriate to cover estimated credit losses on individually evaluated loans determined to be impaired as well as estimated credit losses inherent in the remainder of the loan and lease portfolio, and that estimates of credit losses should reflect consideration of all significant factors that affect the collectibility of the portfolio as of the evaluation date. The policy statement states that prudent, conservative, but not excessive, loan loss allowances that represent management’s best estimate from within an acceptable range of estimated losses are appropriate.
The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation in December 2006 issued final guidance on sound risk management practices for concentrations in commercial real estate lending. The agencies observed that the commercial real estate is an area in which some banks are becoming increasingly concentrated, especially with small- to medium- sized banks that face strong competition in their other business lines. The agencies support banks serving a vital role in their communities by supplying credit for business and real estate development. However, the agencies are concerned that rising commercial real estate loan concentrations may expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in commercial real estate markets. The guidance provides supervisory criteria, including numerical indicators to assist in identifying institutions with potentially significant commercial real estate loan concentrations that may warrant greater supervisory scrutiny, but such criteria are not limits on commercial real estate lending.
California Assembly Bill 1301 was signed by Gov. Schwarzenegger on July 16, 2008 and became law on January 1, 2009. Among other things, the bill eliminated unnecessary applications that consume time and resources of bank licensees and which in many cases are now perfunctory. All of current Article 5 – “Locations of Head Office” of Chapter 3, and all of Chapter 4 – “Branch Offices, Other Places of Business and Automated Teller Machines” were repealed. A new Chapter 4 – “Bank Offices” was added. The new Chapter 4 requires notice to the California Department of Financial Institutions (“CDFI”) the establishment of offices, rather than the current application process. Many of the current branch applications are perfunctory in nature and/or provide for a waiver of application. Banks, on an exception basis, may be subject to more stringent requirements as deemed necessary. As an example, new banks, banks undergoing a change in ownership and banks in less than satisfactory condition may be required to obtain prior approval from the CDFI before establishing offices if such activity is deemed to create an issue of safety and soundness. The bill eliminated unnecessary provisions in the Banking Law that are either outdated or have become undue restrictions to bank licensees. Chapter 6 – “Powers and Miscellaneous Provisions” was repealed. A new Chapter 6 - “Restrictions and Prohibited Practices” was added. This chapter brings together restrictions in bank activities as formerly found in Chapter 18 – “Prohibited Practices and Penalties.” However, in bringing the restrictions into the new chapter, various provisions were updated to remove the need for prior approval by the DFI Commissioner. The bill renumbered current Banking Law sections to align like sections. Chapter 4.5 – “Authorizations for Banks” was added. The purpose of the chapter is to provide exceptions to certain activities that would otherwise be prohibited by other laws outside of the Financial Code. The bill added Article 1.5 - “Loan and Investment Limitations” to Chapter 10 – “Commercial Banks.” This article is new in concept and acknowledges that investment decisions are business decisions – so long as there is a diversification of the investments to spread any risk. The risk is diversified in this article by placing a limitation on the loans and investments that can be made to any one entity. This section is a trade-off for elimination of applications to the DFI for approval of investments in securities, which were repealed.
Other changes AB 1301 made to the Banking Law:
| | • Authorized a bank or trust acting in any capacity under a court or private trust to arrange for the deposit of securities in a securities depository or federal reserve bank, and provided how they may be held by the securities depository; |
| | • Reduced from 5% to 1% the amount of eligible assets to be maintained at an approved depository by an office of a foreign (other nation) bank for the protection of the interests of creditors of the bank’s business in this state or for the protection of the public interest; |
| | • Enabled the CDFI to issue an order against a bank licensee parent or subsidiary; |
| | • Provided that the examinations may be conducted in alternate examination periods if the CDFI concludes that an examination of the state bank by the appropriate federal regulator carries out the purpose of this section, but the CDFI may not accept two consecutive examination reports made by federal regulators; |
| | • Provided that the CDFI may examine subsidiaries of every California state bank, state trust company, and foreign (other nation) bank to the extent and whenever and as often as the CDFI shall deem advisable; |
| | • Enabled the CDFI issue an order or a final order to now include any bank holding company or subsidiary of the bank, trust company, or foreign banking corporation that is violating or failing to comply with any applicable law, or is conducting activities in an unsafe or injurious manner; |
| | • Enabled the CDFI to take action against a person who has engaged in or participated in any unsafe or unsound act with regard to a bank, including a former employee who has left the bank. |
In 2007 California, a new Section 691.1 was added to the Financial Code that exempts from a bank from obtaining a securities permit for the following transactions:
| | · | any offer (but not a sale) not involving a public offering by a bank organized under the laws of this state of its securities |
| | · | the execution and delivery of any agreement for the sale of the securities pursuant to the offer if no part of the consideration for the securities is paid to or received by the bank and none of the securities are issued until the sale of the securities is authorized by the commissioner or exempted from authorization. |
| | · | any stock split by a bank organized under the laws of this state that is effected pursuant to an amendment to its articles, an agreement of merger, or a certificate of ownership that has been approved by the commissioner, unless this exemption is withheld by order of the commissioner |
| | · | any offer or sale of securities by a bank organized under the laws of this state that is either (1) to a person actually approved by the commissioner pursuant to Section 702 of the Financial Code to acquire control of the bank if all of the material terms and conditions of the offer and sale of securities are disclosed in the application for approval specified in Section 702 and the offer and sale of securities is in accordance with the terms and subject to the conditions of the approval to acquire control or (2) in a transaction exempted from the approval requirement of Section 701 by a regulation or an order of the commissioner, unless this exemption is withheld by order of the commissioner. |
In California, effective January 1, 2007, a new law Financial Code Section 854.1 recognizes the ability of mortgage brokers to obtain the benefit of non interest-bearing accounts on trust funds deposited in a “commercial bank.” The provision applies to real estate brokers who collect payments or provide services in connection with a loan secured by a lien on real property and permits a mortgage broker to earn interest on an interest-bearing account at a financial institution. Interest on funds received by a real estate broker who collects payments or provides services for an “institutional investor” in connection with a loan secured by commercial real property may inure to the broker, if agreed to in writing by the broker and the institutional investor. For purposes of this law, commercial real property means real estate improved with other than a one-to-four family residence.
A 2007 California law makes it easier for California banks to accept deposits from local government agencies. Under the old law, local agency deposits over $100,000 had to be secured by collateral. Pursuant to the enactment of Assembly Bill 2011, banks would be able to acquire surplus public deposits exceeding $100,000 without pledging collateral if they participate in a deposit placement service where excess amounts are placed in certificates of deposit at other institutions within a network. Such a network (of which currently there is only one available in the market) permits the entire amount of a customer’s deposit to be FDIC-insured, and the bank taking the original deposit retains the benefit of the full amount of the deposit for lending or other purposes. AB 2011 clarifies that a local agency may deposit up to 30% of its surplus funds in certificates of deposit at a bank, savings association, savings bank, or credit union that participates in such a deposit-sharing network. Since the entire amount of the deposits would be FDIC-insured, a bank would not be required to pledge collateral. The bill permits agencies to make these deposits until January 1, 2012.
It is impossible to predict what effect the enactment of certain of the above-mentioned legislation will have on the Company. Moreover, it is likely that other bills affecting the business of banks may be introduced in the future by the United States Congress or California legislature.
Employees
At December 31, 2008, the Company employed 138 persons on a full-time equivalent basis. The Company believes its employee relations are excellent.
Available Information
The Company files period reports and other reports under the Securities and Exchange Act of 1934 with the Securities and Exchange Commission (SEC). These reports, as well as the Company’s Code of Ethics, are posted and are available at no cost on the Company’s website at http://www.unitedsecuritybank.com as soon as reasonably practical after the Company files such reports with the SEC. The Company’s periodic and other reports filed with the SEC are also available at the SEC’s website (http://www.sec.gov).
Item 1A. Risk Factors
There are risk factors that may affect the Company’s business and impact the results of operations, some of which are beyond the control of the Company.
Difficult market conditions and economic trends have adversely affected the banking industry and could adversely affect the Company’s business, financial condition, results of operations and cash flows.
The Company is operating in a challenging and uncertain economic environment, including generally uncertain conditions nationally and locally in its markets. Financial institutions continue to be affected by declines in the real estate market that have negatively impacted the credit performance of construction, commercial real estate loans, and residential mortgage loans and resulted in significant write-downs of assets by many financial institutions. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to their customers and to each other. The Company retains direct exposure to the residential and commercial real estate markets, and it is affected by these events. Continued declines in real estate values, home sales volumes and financial stress on borrowers as a result of the uncertain economic environment, including job losses, could have an adverse affect on the Company’s borrowers or their customers, which could adversely affect the Company’s business, financial condition, results of operations and cash flows.
The Company’s ability to assess the creditworthiness of customers and to estimate the losses inherent in its credit portfolio is made more complex by these difficult market and economic conditions. The Company also expects to face increased regulation and government oversight as a result of these downward trends. This increased government action may increase the Company’s costs and limit its ability to pursue certain business opportunities. In addition, the Company may be required to pay even higher FDIC deposit insurance premiums than the recently increased level, because financial institution failures resulting from the depressed market conditions and other factors have depleted and may continue to deplete the deposit insurance fund and reduce its ratio of reserves to insured deposits.
A prolonged national economic recession or further deterioration of these conditions in the Company’s markets could drive losses beyond that which is provided for in its allowance for credit losses and result in the following consequences:
| | • | increases in loan delinquencies; |
| | • | increases in nonperforming assets and foreclosures; |
| | • | decreases in demand for the Company’s products and services, which could adversely affect its liquidity position; and |
| | • | decreases in the value of the collateral securing the Company’s loans, especially real estate, which could reduce customers’ borrowing power. |
The Company does not believe these difficult conditions are likely to improve in the near future. A worsening of these conditions would likely exacerbate the adverse effects of these difficult economic conditions on the Company, its customers and the other financial institutions in its market. As a result, the Company may experience increases in foreclosures, delinquencies and customer bankruptcies, as well as more restricted access to funds.
The U.S. Treasury and the FDIC have initiated programs to address economic stabilization, yet the efficacy of these programs in stabilizing the economy and the banking system at large are uncertain.
Current levels of market volatility are unprecedented and could adversely impact the Company’s results of operations and access to capital.
The capital and credit markets have been experiencing volatility and disruption for more than a year. In recent months, the volatility and disruption has reached unprecedented levels. In some cases, the markets have produced downward pressure on stock prices and credit capacity for certain issuers without regard to those issuers’ underlying financial strength. If the current levels of market disruption and volatility continue or worsen, there can be no assurance that the Company will not experience further adverse effects, which may be material, on its ability to access capital and on its business, financial condition and results of operations.
Liquidity risk could impair the Company’s ability to fund operations and jeopardize its financial condition.
Liquidity is essential to the Company’s business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources could have a substantial negative effect on its liquidity. The Company’s access to funding sources in amounts adequate to finance its activities or on terms which are acceptable to it could be impaired by factors that affect the Company specifically or the financial services industry or economy in general. Factors that could detrimentally impact the Company’s access to liquidity sources include a decrease in the level of its business activity as a result of a downturn in the markets in which its loans are concentrated or adverse regulatory action against it. The Company’s ability to borrow could also be impaired by factors that are not specific to it, such as a disruption in the financial markets or negative views and expectations about the prospects for the financial services industry in light of the recent turmoil faced by banking organizations and the continued deterioration in credit markets.
The Company’s financial performance is subject to interest rate risk.
The Company’s operations are greatly influenced by general economic conditions and by related monetary and fiscal policies of the federal government. Deposit flows and the funding costs are influenced by interest rates of competing investments and general market rates of interest. Lending activities are affected by the demand for loans, which in turn is affected by the interest rates at which such financing may be offered and by other factors affecting the availability of funds.
The Company’s performance is substantially dependent on net interest income, which is the difference between the interest income received from interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities. To reduce the Company’s exposure to interest rate fluctuations, management seeks to manage the balances of interest sensitive assets and liabilities, and maintain appropriate maturity and repricing parameters for these assets and liabilities. A mismatch between the amount of rate sensitive assets and rate sensitive liabilities in any time period may expose the Company to interest rate risk. Generally, if rate sensitive assets exceed rate sensitive liabilities, the net interest margin will be positively impacted during a rising rate environment and negatively impacted during a declining rate environment. When rate sensitive liabilities exceed rate sensitive assets, the net interest margin will generally be positively impacted during a declining rate environment and negatively impacted during a rising rate environment.
Increases in the level of interest rates may reduce the overall level of loans originated by the Company, and, thus, the amount of loan and commitment fees earned, as well as the market value of investment securities and other interest-earning assets. Moreover, fluctuations in interest rates may also result in disintermediation, which is the flow of funds away from depository institutions into direct investments, such as corporate securities and other investment vehicles which, because of the absence of federal deposit insurance, generally pay higher rates of return than depository institutions.
The continued deterioration of local economic conditions in the Company’s market area could hurt profitability.
The Company’s operations are located primarily in Fresno, Madera, Kern, and Santa Clara Counties, and are concentrated in Fresno County and surrounding areas. As a result of this geographic concentration, the Company’s financial results depend largely upon economic conditions in these areas. The local economy in the Company’s market areas rely heavily on agriculture, real estate, professional and business services, manufacturing, trade and tourism. The significant economic downturn experienced in the sub-prime lending and credit markets since the later part of 2007, has negatively impacted the Company’s operations and financial condition to some degree, and may further worsen with further deterioration of local and state-wide economic conditions. Poor economic conditions could cause the Company to incur losses associated with higher default rates and decreased collateral values in the loan portfolio.
Concentrations in commercial and industrial loans, real estate-secured commercial loans, and real estate construction loans, may expose the Company to increased lending risks, especially in the event of a recession.
The Company has significant concentrations in commercial real estate and real estate construction loans. As of December 31, 2008, 14.9%, and 21.8% of the Company’s loan portfolio was concentrated in these two categories, respectively. In addition, the Company has many commercial loans to businesses in the construction and real estate industry. There has been significant volatility in real estate values in the Company’s market area in recent years, and the occurrence of an extended real estate recession affecting these market areas would likely reduce the security for many of the Company’s loans and adversely affect the ability of many of borrowers to repay loan balances due the Company and require increased provisions to the allowance for loan losses. Therefore, the Company’s financial condition and results of operations may be adversely affected by a decline in the value of the real estate securing the Company’s loans.
The small to medium-sized businesses that the Company lends to may have fewer resources to weather a downturn in the economy, which may impair a borrower’s ability to repay a loan to the Company that could materially harm the Company’s operating results.
The Company targets its business development and marketing strategy primarily to serve the banking and financial services needs of small to medium-sized businesses. These small to medium-sized businesses frequently have smaller market share than their competition, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience significant volatility in operating results. Any one or more of these factors may impair the borrower’s ability to repay a loan. In addition, the success of a small to medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay a loan. Economic downturns and other events that negatively impact the Company’s market areas could cause the Company to incur substantial credit losses that could negatively affect the Company’s results of operations, financial condition and cash flows.
The Company faces strong competition, which may adversely affect its operating results.
In recent years, competition for bank customers, the source of deposits and loans for the Company has greatly intensified. This competition includes:
| · | larger regional and national banks and other FDIC insured depository institutions in many of the communities the Company serves; |
| · | finance companies, investment banking and brokerage firms, and insurance companies that offer bank-like products; |
| · | credit unions, which can offer highly competitive rates on loans and deposits because they receive tax advantages not available to commercial banks; and |
| · | technology-based financial institutions including large national and super-regional banks offering on-line deposit, bill payment, and mortgage loan application services. |
Some of the financial services organizations with which the Company competes are not subject to the same degree of regulation as is imposed on bank holding companies and federally insured financial institutions. As a result, these non-bank competitors have certain advantages over the Company in accessing funding and in providing various banking-related services.
By virtue of their larger capital position, regional and national banks have substantially larger lending limits than the Company, and can provide certain services to their customers which the Company is not able to offer directly, such as trust and international services. Many of these larger banks also operate with greater economies of scale which result in lower operating costs than the Company on a per-unit basis.
Other existing single or multi-branch community banks, or new community bank start-ups, have marketing strategies similar to United Security Bancshares. These other community banks can open new branches in the communities the Company serves and compete directly for customers who want the high level of service community banks offer. Other community banks also compete for the same management personnel and the same potential acquisition and merger candidates. Ultimately, competition can drive down the Company’s interest margins and reduce profitability, as well as make it more difficult for the Company to achieve its growth objectives.
The Company’s growth and expansion strategy may not prove to be successful and as a result, its market value and profitability may suffer.
The Company plans to grow operations within its market area and expand into new market areas when it makes strategic business sense, however the Company’s capacity to manage any such growth will depend primarily on the ability to attract and retain qualified personnel, monitor operations, maintain earnings and control costs. The Company expects to continue to grow its assets and deposits, the products and services which it offers and accordingly the scale of its operations. The Company’s ability to manage growth successfully will depend on the ability to maintain cost controls and asset quality while attracting additional loans and deposits on favorable terms. If the Company grows too quickly and is not able to control costs and maintain asset quality, this rapid growth could materially adversely affect the financial performance of the Company. The future successful growth of the Company will depend on the ability of its officers and other key employees to continue to implement and improve operational, credit, financial, management and other internal risk controls and processes, reporting systems and procedures, and to manage a growing number of customer relationships. The Company may not successfully implement improvements to management information and control systems, and control procedures and processes, in an efficient or timely manner and may discover deficiencies in existing systems and controls. In particular, the Company’s controls and procedures must be able to accommodate an increase in expected loan volume and the infrastructure that comes with growth. Thus, the Company’s growth strategy may divert management from existing businesses and may require the Company to incur additional expenditures to expand its administrative and operational infrastructure. If the Company is unable to manage future expansion in its operations, it may experience compliance and operational problems, need to slow the pace of growth, or need to incur additional expenditures beyond current projections to support such growth, any one of which could adversely affect the Company’s business and profitability.
The Company may need to raise additional capital in the future and such capital may not be available when needed or at all.
The Company may need to raise additional capital in the future to provide it with sufficient capital resources and liquidity to meet its commitments and business needs. In addition, the Company may elect to raise additional capital to support its business or to finance acquisitions, if any. The Company’s ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of its control, and its financial performance. The ongoing liquidity crisis and the loss of confidence in financial institutions may increase the Company’s cost of funding and limit its access to some of its customary sources of capital, including, but not limited to, inter-bank borrowings, repurchase agreements and borrowings from the discount window of the Federal Reserve.
The Company cannot assure you that such capital will be available to it on acceptable terms or at all. Any occurrence that may limit its access to the capital markets, such as a decline in the confidence of investors, depositors of the Banks or counterparties participating in the capital markets, may adversely affect the Company’s capital costs and its ability to raise capital and, in turn, its liquidity. An inability to raise additional capital on acceptable terms when needed could have a material adverse effect on the Company’s business, financial condition and results of operations.
The loss of any of the Company’s executive officers or key personnel could be damaging to the business.
The Company depends upon the skills and reputations of its executive officers and key employees for its future success. The loss of any of these key persons or the inability to attract and retain other key personnel could adversely affect the Company’s business operations.
The Company could experience loan losses, which exceed the overall allowance for loan losses.
The risk of credit losses on loans and leases varies with, among other things, general economic conditions, the type of loan being made, the creditworthiness of the borrower, and, in the case of collateralized loans, the value and marketability of the collateral. The Company maintains an allowance for loan losses based upon, among other things, historical experience, an evaluation of economic conditions, and regular reviews of delinquencies and loan portfolio quality. Based upon such factors, management makes various assumptions and determinations about the ultimate collectibility of the loan portfolio and provides an allowance for losses based upon a percentage of the outstanding balances and for specific loans where their collectibility is considered to be questionable.
As of December 31, 2008, the Company’s allowance for loan losses was approximately $15.1 million representing 2.75% of gross outstanding loans. Although management believes that the allowance is adequate, there can be no absolute assurance that it will be sufficient to cover future loan losses. Although the Company uses the best information available to make determinations with respect to adequacy of the allowance for loan losses, future adjustments may be necessary if economic conditions change substantially from the assumptions used or if negative developments occur with respect to non-performing or performing loans. If management’s assumptions or conclusions prove to be incorrect and the allowance for loan losses is not adequate to absorb future losses, or if Company’s regulatory agencies require an increase in the allowance for loan losses, the Company’s earnings, and potentially its capital, could be significantly and adversely impacted.
The Company may become subject to environmental liability risk associated with lending activities.
A significant portion of the Company’s loan portfolio is secured by real property. During the ordinary course of business, we may foreclose on and take title to properties securing certain loans. In doing so, there is a risk that hazardous or toxic substances could be found on these properties. If hazardous or toxic substances are found, the Company may be liable for remediation costs, as well as for personal injury and property damage. Environmental laws may require the Company to incur substantial expenses and may materially reduce the affected property’s value or limit the ability to use or sell the affected property. In addition, future laws or more stringent interpretations or enforcement policies with respect to existing laws may increase our exposure to environmental liability. Although the Company has policies and procedures to perform an environmental review before initiating any foreclosure action on nonresidential real property, these reviews may not be sufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard could have a material adverse effect on the Company’s financial condition and results of operations.
The regulatory environment under which the Company operates may have an adverse impact on the banking industry.
The Company is subject to extensive regulatory supervision and oversight from both federal and state authorities. Regulatory oversight of the Company is provided by the Federal Reserve Bank (FRB) and the California Department of Financial Institutions (DFI). Future legislation and government may adversely impact the Company and the commercial banking industry in general. Future regulatory changes may also alter the structure and competitive relationship among financial institutions.
The Company may be exposed to compliance risk resulting from violations or nonconformity with laws, rules, regulations, internal policies and procedures, or ethical standards set forth by regulatory authorities. The Company may also be subject to compliance risk in situations where laws or rules governing certain products or activities of the Company’s customers may be uncertain or untested. Compliance risk exposes the Company to fines, civil money penalties, payment of damages, and the potential voiding of contracts. Compliance risk can result in diminished reputation, reduced franchise value, limited business opportunities, and reduced growth potential.
If the Company lost a significant portion of its low-cost core deposits, it would negatively impact profitability.
The Company’s profitability depends in part on its success in attracting and retaining a stable base of low-cost deposits. As of December 31, 2008, noninterest-bearing checking accounts comprised 29.4% of the Company’s deposit base, and interest-bearing checking and money market accounts comprised an additional 8.0% and 18.8%, respectively. The Company considers these deposits to be core deposits. If the Company lost a significant portion of these low-cost deposits, it would negatively impact its profitability and long-term growth objectives. While Management generally does not believe these deposits are sensitive to interest-rate fluctuations, the competition for these deposits in the Company’s market area is strong and if the Company were to lose a significant portion of these low-cost deposits, it would negatively affect business operations.
The Company’s Internal controls and procedures may fail or be circumvented.
Management regularly reviews and updates our internal controls, disclosure controls and procedures, and corporate governance policies and procedures. Any system of controls, however well designed and operated, is based, in part, on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the Company’s controls and procedures or failure to comply with regulations related to controls and procedures could have a material adverse effect the Company’s business, results of operations and financial condition.
The Company’s information systems may experience an interruption or breach in security.
The Company relies heavily on communications and information systems to conduct its business. Any failure, interruption or breach in security of these systems could result in failures or disruptions in customer relationship management, general ledger, deposit, loan and other systems. While the Company has policies and procedures designed to prevent or limit the effect of the failure, interruption or security breach of its information systems, there can be no assurance that we can prevent any such failures, interruptions or security breaches or, if they do occur, that they will be adequately addressed. The occurrence of any failures, interruptions or security breaches of the Company’s information systems could damage our reputation, result in a loss of customer business, subject the Company to additional regulatory scrutiny, or expose it to civil litigation and possible financial liability, any of which could have a material adverse effect on the Company’s financial condition and results of operations.
The Company continually encounters technological change.
The financial services industry is continually undergoing rapid technological change with frequent introductions of new technology-driven products and services. The effective use of technology increases efficiency and enables financial institutions to better serve customers and to reduce costs. The Company’s future success depends, in part, upon its ability to address the needs of its customers by using technology to provide products and services that will satisfy customer demands, as well as to create additional efficiencies in the Company’s operations. Many of the Company’s competitors have substantially greater resources to invest in technological improvements. We may not be able to effectively implement new technology-driven products and services or be successful in marketing these products and services to the company’s customers and even if such products and services are implemented, the Company may incur substantial costs in doing so. Failure to successfully keep pace with technological change affecting the financial services industry could have a material adverse impact on the Company’s business, financial condition and results of operations
The Company is Subject to Other-than-temporary Impairment Risk
The Company recognizes an impairment charge when the decline in the fair value of equity, debt securities and cost-method investments below their cost basis are judged to be other-than-temporary. Significant judgment is used to identify events or circumstances that would likely have a significant adverse effect on the future use of the investment. The Company considers various factors in determining whether an impairment is other-than-temporary, including the severity and duration of the impairment, forecasted recovery, the financial condition and near-term prospects of the investee, and our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery in market value. Information about unrealized gains and losses is subject to changing conditions. The values of securities with unrealized gains and losses will fluctuate, as will the values of securities that we identify as potentially distressed. Our current evaluation of other-than-temporary impairments reflects our intent to hold securities for a reasonable period of time sufficient for a forecasted recovery of fair value. However, our intent to hold certain of these securities may change in future periods as a result of facts and circumstances impacting a specific security. If our intent to hold a security with an unrealized loss changes, and we do not expect the security to fully recover prior to the expected time of disposition, we will write down the security to its fair value in the period that our intent to hold the security changes.
The process of evaluating the potential impairment of goodwill and other intangibles is highly subjective and requires significant judgment. The Company estimates expected future cash flows of its various businesses and determines the carrying value of these businesses. The Company exercises judgment in assigning and allocating certain assets and liabilities to these businesses. The Company then compares the carrying value, including goodwill and other intangibles, to the discounted future cash flows. If the total of future cash flows is less than the carrying amount of the assets, an impairment loss is recognized based on the excess of the carrying amount over the fair value of the assets. Estimates of the future cash flows associated with the assets are critical to these assessments. Changes in these estimates based on changed economic conditions or business strategies could result in material impairment charges in future periods.
If the goodwill that the Company recorded in connection with a business acquisition becomes impaired, it could require charges to earnings, which would have a negative impact on the Company’s financial condition, results of operations and cash flows.
Goodwill represents the amount of acquisition cost over the fair value of net assets the Company acquired in the purchase of another financial institution. The Company reviews goodwill for impairment at least annually, or more frequently if events or changes in circumstances indicate the carrying value of the asset might be impaired.
The Company determines impairment by comparing the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. Any such adjustments are reflected in the Company’s results of operations in the periods in which they become known. At December 31, 2008, the Company’s goodwill totaled $10.4 million. While the Company has not recorded any such impairment charges since it initially recorded the goodwill, there can be no assurance that the Company’s future evaluations of goodwill will not result in findings of impairment and related write-downs, which may have a material adverse effect on its financial condition, results of operations and cash flows.
The Company relies on dividends from its subsidiaries for most of its revenue.
United Security Bancshares is a separate and distinct legal entity from its subsidiaries. The Company receives substantially all of its revenue from dividends from its subsidiary, United Security Bank. These dividends are the principal source of funds to pay dividends on common stock and interest on the Company’s junior subordinated debt. Various federal and/or state laws and regulations limit the amount of dividends that United Security Bank and certain non-bank subsidiaries may pay to United Security Bancshares. Also, United Security Bancshares’ right to participate in a distribution of assets upon a subsidiary’s liquidation or reorganization is subject to the prior claims of the subsidiary’s creditors. In the event United Security Bank is unable to pay dividends to United Security Bancshares, the Company may not be able to service debt, pay obligations or pay dividends on common stock. The inability to receive dividends from United Security Bank could have a material adverse effect on United Security Bancshares’ business, financial condition and results of operations.
The holders of the Company’s junior subordinated debentures have rights that are senior to those of the Company’s shareholders.
On July 25, 2007 the Company issued $15.5 million of floating rate junior subordinated debentures in connection with a $15.0 million trust preferred securities issuance by its subsidiary, United Security Bancshares Capital Trust II. The junior subordinated debentures mature in July 2037.
The Company conditionally guarantees payments of the principal and interest on the trust preferred securities. The Company’s junior subordinated debentures are senior to holders of common stock. As a result, the Company must make payments on the junior subordinated debentures (and the related trust preferred securities) before any dividends can be paid on our common stock and, in the event of bankruptcy, dissolution or liquidation, the holders of the debentures must be satisfied before any distributions can be made to the holders of common stock. The Company has the right to defer distributions on our junior subordinated debentures (and the related trust preferred securities) for up to five years, during which time no dividends may be paid to holders of common stock.
Severe weather, natural disasters, acts of war or terrorism and other external events could significantly impact the Company’s business.
Severe weather, natural disasters, including but not limited to earthquakes and droughts, acts of war or terrorism and other adverse external events could have a significant impact on the Company’s ability to conduct business. Such events could affect the stability of our deposit base, impair the ability of borrowers to repay outstanding loans, impair the value of collateral securing loans, cause significant property damage, result in loss of revenue and/or cause the Company to incur additional expenses. Severe weather or natural disasters, acts of war or terrorism or other adverse external events may occur in the future. Although management has established disaster recovery policies and procedures, there can be no assurance of the effectiveness of such policies and procedures, and the occurrence of any such event could have a material adverse effect on the Company’s business, financial condition and results of operations.
Item 1B. - Unresolved Staff Comments
The Company had no unresolved staff comments at December 31, 2008.
Item 2 - Properties
The Bank’s Main bank branch is located at 2151 West Shaw Avenue, Fresno, California. The Company owns the building and leases the land under a sublease dated December 1, 1986 between Central Bank and USB. The current sublessor under the master ground lease is Bank of the West, which acquired the position through the purchase of Central Bank. The lessor under the ground lease (Master Lease) is Thomas F. Hinds. The lease expires on December 31, 2015 and the Company has options to extend the term for four (4) ten-year periods and one seven (7) year period.
The Company leases the banking premises of approximately 6,450 square feet for its second of three Fresno branches at 7088 N. First Ave, Fresno, California., under a lease which commenced August 2005 for a term of ten years expiring in July 2015. The branch was previously located at 1041 E. Shaw Avenue, Fresno, California, under a lease extension expiring February 28, 2005. The lease was renewed until August 2005. The 7088 N. First location provides space for the relocated branch as well as the Real Estate Construction Department and the Indirect Consumer Lending Department.
The Company leases the Oakhurst bank branch located at the Old Mill Village Shopping Center, 40074 Highway 49, Oakhurst, California. The branch facility consists of approximately 5,000 square feet with a lease term of 15 years ending April 2014, and has two five-year options to extend the lease term after that date.
The Company owns the Caruthers bank branch located at 13356 South Henderson, Caruthers, California, which consists of approximately 5,000 square feet of floor space.
The Company owns the San Joaquin branch facilities located at 21574 Manning Avenue, San Joaquin, California. The bank branch is approximately 2,500 square feet.
The Company owns the Firebaugh bank branch located at 1067 O Street, Firebaugh, California. The premises are comprised of approximately 4,666 square feet of office space situated on land totaling approximately one-third of an acre.
The Company owns the Coalinga bank branch located at 145 East Durian, Coalinga, California. The office building has a total of 6,184 square feet of interior floor space situated on approximately 0.45 acres of land.
The Company leases the Convention Center branch located at 855 “M” Street, Suite 130, Fresno, California. Total space leased is approximately 4,520 square feet, and was occupied during March 2004. The fifteen-year lease expires in March 2019. There are no extension provisions.
The Company owns the Taft branch office premises located at 523 Cascade Place, Taft, California. The branch facilities consist of approximately 9,200 square feet of office space.
The Company owns the branch facilities located at 3404 Coffee Road, Bakersfield, California, which has approximately 6,130 square feet of office space located on 1.15 acres.
The Company leases the Campbell branch located at 125 E. Campbell Ave, Campbell, California, which has approximately 6,995 square feet which it occupied after the merger completed in February 2007. The lease expires on December 31, 2010.
The Company subleases the space for its USB Financial Services offices at 855 “M” Street, Suite 1120, Fresno, California from Centex Homes, Inc. The subleased facility totals 3,656 square feet and the lease expires on March 31, 2009.
The Company owns its administrative headquarters at 2126 Inyo Street, Fresno, California. The facility consists of approximately 21,400 square feet. A portion of the premises has been subleased to a third-party under a lease term of approximately seven years.
Item 3 - Legal Proceedings
From time to time, the Company is party to claims and legal proceedings arising in the ordinary course of business. At this time, the management of the Company is not aware of any material pending litigation proceedings to which it is a party or has recently been party to, which will have a material adverse effect on the financial condition or results of operations of the Company.
Item 4 - Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of shareholders during the fourth quarter of 2008.
PART II
Item 5 - Market for the Registrant's Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
Trading History
The Company became a NASDAQ National Market listed company on May 31, 2001, then became a Global Select listed company during 2006, and trades under the symbol UBFO.
The Company currently has four market makers for its common stock. These include, Stone & Youngberg, LLC, Howe Barnes Hoeffer & Arnett, Sandler O’Neill & Partners, and Hill Thompson, Magid & Company. The Company is aware of two other securities dealers: Smith Barney and Dean Witter Reynolds Inc., which periodically act as brokers in the Company's stock.
On March 28, 2006, the Company announced a 2-for-1 stock split of the Company’s no-par common stock payable May 1, 2006 effected in the form of a 100% stock dividend. Share information for all periods presented in this 10-K have been restated to reflect the effect of the stock split.
During the third quarter ended September 30, 2008 and the fourth quarter ended December 31, 2008, the Company declared 1% stock dividends. Share information for all periods presented in this 10-K has been restated to reflect the effect of the 1% stock dividends.
The Company has been included in the Russell 2000 Stock Index since June 2006. The inclusion of the Company’s stock in the index has provided additional exposure for the Company in equity markets, and increased the transaction volume.
The following table sets forth the high and low closing sales prices by quarter for the Company's common stock, for the years ended December 31, 2008 and 2007.
| | | Closing Prices | | | Volume | |
| Quarter | | High | | | Low | | | | |
| 4th Quarter 2008 | | $ | 16.06 | | | $ | 7.17 | | | | 913,800 | |
| 3rd Quarter 2008 | | $ | 17.70 | | | $ | 13.59 | | | | 1,004,500 | |
| 2nd Quarter 2008 | | $ | 17.33 | | | $ | 13.38 | | | | 1,260,000 | |
| 1st Quarter 2008 | | $ | 17.82 | | | $ | 12.52 | | | | 1,623,900 | |
| | | | | | | | | | | | | |
| 4th Quarter 2007 | | $ | 20.00 | | | $ | 14.34 | | | | 1,505,900 | |
| 3rd Quarter 2007 | | $ | 21.00 | | | $ | 13.99 | | | | 1,167,700 | |
| 2nd Quarter 2007 | | $ | 22.63 | | | $ | 17.14 | | | | 2,083,400 | |
| 1st Quarter 2007 | | $ | 25.00 | | | $ | 19.07 | | | | 1,649,400 | |
At January 31, 2008, there were approximately 864 record holders of common stock of the Company. This does not reflect the number of persons or entities who hold their stock in nominee or street name through various brokerage firms.
Dividends
The Company's shareholders are entitled to cash dividends when and as declared by the Company’s Board of Directors out of funds legally available therefore. Dividends paid to shareholders by the Company are subject to restrictions set forth in California General Corporation Law, which provides that a corporation may make a distribution to its shareholders if retained earnings immediately prior to the dividend payout are at least equal the amount of the proposed distribution. As a bank holding company without significant assets other than its equity position in the Bank, the Company’s ability to pay dividends to its shareholders depends primarily upon dividends it receives from the Bank. Such dividends paid by the Bank to the Company are subject to certain limitations. See “Management’s Discussion and Analysis of Financial and Results of Operations – Regulatory Matters”.
The Company paid cash dividends to shareholders of $0.13 per share on January 23, 2008, and April 23, 2008. The Company distributed a 1% stock dividend to shareholders on July 23, 2008, and then again on October 22, 2008. During the previous year, the Company paid cash dividends to shareholders of $0.125 per share on January 25, 2007, April 18, 2007, July 18, 2007 and October 24, 2007.
The amount and payment of dividends by the Company to shareholders are set by the Company's Board of Directors with numerous factors involved including the Company's earnings, financial condition and the need for capital for expanded growth and general economic conditions. No assurance can be given that cash or stock dividends will be paid in the future.
Securities Authorized for Issuance under Equity Compensation Plans
The following table sets forth securities authorized for issuance under equity compensation plans as for December 31, 2008.
Plan Category | | Number of securities to be issued upon exercise of outstanding options, warrants and rights (column a) | | | Weighted-average exercise price of outstanding options, warrants and rights | | | Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) | |
| Equity compensation plans approved by security holders | | | 175,967 | | | $ | 15.74 | | | | 311,335 | |
| Equity compensation plans not approved by security holders | | | N/A | | | | N/A | | | | N/A | |
| | | | | | | | | | | | | |
| Total | | | 175,967 | | | $ | 15.74 | | | | 311,335 | |
A complete description of the above plans is included in Note 12 of the Company’s Financial Statements in Item 8 of this Annual Report on Form 10K, and is hereby incorporated by reference.
Purchases of Equity Securities by Affiliates and Associated Purchasers
| | | | | | | | | Total Number of | | | Maximum Number | |
| | | | | | Weighted | | | Shares Purchased | | | of Shares That May | |
| | | Total Number | | | Average | | | as Part of Publicly | | | Yet be Purchased | |
| | | Of Shares | | | Price Paid | | | Announced Plan | | | Under the Plans | |
| Period | | Purchased | | | per Share | | | or Program | | | or Programs | |
| 10/01/08 to 10/31/08 | | | 249 | | | $ | 12.09 | | | | 249 | | | | 197,993 | |
| 11/01/08 to 11/30/08 | | | 16,773 | | | $ | 8.89 | | | | 16,773 | | | | 181,220 | |
| 12/01/08 to 12/31/08 | | | 5,893 | | | $ | 10.38 | | | | 5,893 | | | | 175,327 | |
| | | | | | | | | | | | | | | | | |
| Total fourth quarter 2008 | | | 22,915 | | | $ | 9.31 | | | | 22,915 | | | | | |
On August 30, 2001 the Company announced that its Board of Directors approved a plan to repurchase, as conditions warrant, up to 280,000 shares (560,000 shares adjusted for May 2006 stock split) of the Company's common stock on the open market or in privately negotiated transactions. The duration of the program was open-ended and the timing of purchases was dependent on market conditions. A total of 215,423 shares (430,846 shares adjusted for May 2006 stock split) had been repurchased under that plan as of December 31, 2003, at a total cost of $3.7 million.
On February 25, 2004 the Company announced a second stock repurchase plan under which the Board of Directors approved a plan to repurchase, as conditions warrant, up to 276,500 shares (553,000 shares adjusted for May 2006 stock split) of the Company's common stock on the open market or in privately negotiated transactions. As with the first plan, the duration of the new program is open-ended and the timing of purchases will depend on market conditions. Concurrent with the approval of the new repurchase plan, the Board terminated the 2001 repurchase plan and canceled the remaining 64,577 shares (129,154 shares adjusted for May 2006 stock split) yet to be purchased under the earlier plan.
On May 16, 2007, the Company announced another stock repurchase plan to repurchase, as conditions warrant, up to 610,000 shares of the Company's common stock on the open market or in privately negotiated transactions. The repurchase plan represents approximately 5.00% of the Company's currently outstanding common stock. The duration of the program is open-ended and the timing of purchases will depend on market conditions. Concurrent with the approval of the new repurchase plan, the Company canceled the remaining 75,733 shares available under the 2004 repurchase plan.
During the year ended December 31, 2008, 89,001 shares were repurchased at a total cost of $1.21 million and an average per share price of $13.70.
Financial Performance
The following performance graph does not constitute soliciting material and should not be deemed filed incorporated by reference into any other Company under the Securities Act of 1933 or the Securities Exchange Act of 1934, except to the extent the Company specifically incorporates the performance graph by reference therein.
| | | Period Ending | |
| Index | | 12/31/03 | | | 12/31/04 | | | 12/31/05 | | | 12/31/06 | | | 12/31/07 | | | 12/31/08 | |
| United Security Bancshares | | | 100.00 | | | | 95.89 | | | | 117.85 | | | | 190.21 | | | | 122.88 | | | | 96.96 | |
| Russell 2000 | | | 100.00 | | | | 118.33 | | | | 123.72 | | | | 146.44 | | | | 144.15 | | | | 95.44 | |
| Russell 3000 | | | 100.00 | | | | 111.95 | | | | 118.80 | | | | 137.47 | | | | 144.54 | | | | 90.61 | |
| SNL Bank $500M-$1B Index | | | 100.00 | | | | 113.32 | | | | 118.18 | | | | 134.41 | | | | 107.71 | | | | 69.02 | |
Item 6 - Selected Financial Data
The following table sets forth certain selected financial data for the Bank for each of the years in the five-year periods ended December 31, 2008 and should be read in conjunction with the more detailed information and financial statements contained elsewhere herein (in thousands except per share data and ratios).
| | | December 31, | |
(in thousands except per share data and ratios) | | 2008 | | | 2007 | | | 2006 | | | 2005 | | | 2004 | |
Summary of Year-to-Date Earnings: | | | | | | | | | | | | | | | |
| Interest income and loan fees | | $ | 45,147 | | | $ | 57,156 | | | $ | 47,356 | | | $ | 38,898 | | | $ | 30,874 | |
| Interest expense | | | 14,938 | | | | 20,573 | | | | 14,175 | | | | 9,658 | | | | 6,433 | |
| Net interest income | | | 30,209 | | | | 36,583 | | | | 33,181 | | | | 29,240 | | | | 24,441 | |
| Provision for credit losses | | | 9,598 | | | | 5,697 | | | | 880 | | | | 1,140 | | | | 1,145 | |
| Net interest income after | | | | | | | | | | | | | | | | | | | | |
| Provision for credit losses | | | 20,611 | | | | 30,886 | | | | 32,301 | | | | 28,100 | | | | 23,296 | |
| Noninterest income | | | 8,343 | | | | 9,664 | | | | 9,031 | | | | 6,280 | | | | 4,742 | |
| Noninterest expense | | | 23,279 | | | | 22,732 | | | | 19,937 | | | | 16,982 | | | | 14,667 | |
| Income before taxes on income | | | 5,675 | | | | 17,818 | | | | 21,395 | | | | 17,398 | | | | 13,371 | |
| Taxes on income | | | 1,605 | | | | 6,561 | | | | 8,035 | | | | 6,390 | | | | 4,966 | |
| Net Income | | $ | 4,070 | | | $ | 11,257 | | | $ | 13,360 | | | $ | 11,008 | | | $ | 8,405 | |
Per Share Data: | | | | | | | | | | | | | | | | | | | | |
| Net Income – Basic | | $ | 0.34 | | | $ | 0.93 | | | $ | 1.15 | | | $ | 0.95 | | | $ | 0.73 | |
| Net Income – Diluted | | $ | 0.34 | | | $ | 0.93 | | | $ | 1.14 | | | $ | 0.94 | | | $ | 0.73 | |
| Average shares outstanding – Basic | | | 12,048,728 | | | | 12,165,475 | | | | 11,572,407 | | | | 11,598,382 | | | | 11,486,848 | |
| Average shares outstanding - Diluted | | | 12,052,150 | | | | 12,200,920 | | | | 11,692,705 | | | | 11,683,360 | | | | 11,562,309 | |
| Cash dividends paid | | $ | 0.26 | | | $ | 0.50 | | | $ | 0.43 | | | $ | 0.35 | | | $ | 0.325 | |
| | | | | | | | | | | | | | | | | | | | | |
Financial Position at Period-end: | | | | | | | | | | | | | | | | | | | | |
| Total assets | | $ | 761,077 | | | $ | 771,715 | | | $ | 678,314 | | | $ | 628,859 | | | $ | 611,696 | |
| Total net loans and leases | | | 533,671 | | | | 585,580 | | | | 491,204 | | | | 409,409 | | | | 390,334 | |
| Total deposits | | | 508,486 | | | | 634,617 | | | | 587,127 | | | | 546,460 | | | | 536,672 | |
| Total shareholders' equity | | | 79,610 | | | | 82,431 | | | | 66,042 | | | | 59,014 | | | | 53,236 | |
| Book value per share | | $ | 6.63 | | | $ | 6.95 | | | $ | 5.84 | | | $ | 5.19 | | | $ | 4.69 | |
Selected Financial Ratios: | | | | | | | | | | | | | | | | | | | | |
| Return on average assets | | | 0.52 | % | | | 1.47 | % | | | 2.04 | % | | | 1.76 | % | | | 1.52 | % |
| Return on average shareholders' equity | | | 4.93 | % | | | 13.73 | % | | | 20.99 | % | | | 19.46 | % | | | 16.81 | % |
| Average shareholders' equity to average assets | | | 10.60 | % | | | 10.73 | % | | | 9.70 | % | | | 9.02 | % | | | 9.01 | % |
| Allowance for credit losses as a percentage of total nonperforming loans | | | 29.50 | % | | | 50.45 | % | | | 64.13 | % | | | 55.62 | % | | | 42.51 | % |
| Net charge-offs to average loans | | | 0.92 | % | | | 0.76 | % | | | 0.05 | % | | | 0.15 | % | | | 0.12 | % |
| Allowance for credit losses as a percentage of period-end loans | | | 2.75 | % | | | 1.83 | % | | | 1.67 | % | | | 1.86 | % | | | 1.82 | % |
| Dividend payout ratio | | | 76.47 | % | | | 53.12 | % | | | 38.18 | % | | | 38.50 | % | | | 43.16 | % |
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Overview
Certain matters discussed or incorporated by reference in this Annual Report on Form 10-K are forward-looking statements that are subject to risks and uncertainties that could cause actual results to differ materially from those projected in the forward-looking statements. Such risks and uncertainties include, but are not limited to, those described in Management’s Discussion and Analysis of Financial Condition and Results of Operations. Such risks and uncertainties include, but are not limited to, the following factors: i) competitive pressures in the banking industry and changes in the regulatory environment; ii) exposure to changes in the interest rate environment and the resulting impact on the Company’s interest rate sensitive assets and liabilities; iii) decline in the health of the economy nationally or regionally which could reduce the demand for loans or reduce the value of real estate collateral securing most of the Company’s loans; iv) credit quality deterioration that could cause an increase in the provision for loan losses; v) Asset/Liability matching risks and liquidity risks; volatility and devaluation in the securities markets, and vi) expected cost savings from recent acquisitions are not realized. Therefore, the information set forth therein should be carefully considered when evaluating the business prospects of the Company.
On June 12, 2001, the United Security Bank (the “Bank”) became the wholly owned subsidiary of United Security Bancshares (the “Company”) through a tax-free holding company reorganization, accounted for on a basis similar to the pooling of interest method. In the transaction, each share of Bank stock was exchanged for a share of Company stock on a one-to-one basis. No additional equity was issued as part of this transaction. In the following discussion, references to the Bank are references to United Security Bank. References to the Company are references to United Security Bancshares (including the Bank).
On June 28, 2001, United Security Bancshares Capital Trust I (the “Trust”) was formed as a Delaware business trust for the sole purpose of issuing Trust Preferred securities. On July 16, 2001, the Trust completed the issuance of $15 million in Trust Preferred securities, and concurrently, the Trust used the proceeds from that offering to purchase Junior Subordinated Debentures of the Company. The Company contributed $13.7 million of the $14.5 million in net proceeds received from the Trust to the Bank to increase its regulatory capital and used the rest for the Company’s business. Effective January 1, 2007, the Company adopted the fair value provisions of SFAS No. 159 for its junior subordinated debt issued by the Trust. As a result of the adoption of SFAS No. 159, the Company recorded a fair value adjustment of $1.3 million, reflected as an adjustment to beginning retained earnings. On July 25, 2007, the Company redeemed the $15.0 million in subordinated debentures plus accrued interest of $690,000 and a 6.15% prepayment penalty totaling $922,500. Concurrently, the Trust Preferred securities issued by Capital Trust I were redeemed. The prepayment penalty of $922,500 had previously been a component of the fair value adjustment for the junior subordinated debt at the initial adoption of SFAS No. 159.
Effective December 31, 2001, United Security Bank formed a subsidiary Real Estate Investment Trust (“REIT”) through which preferred stock was offered to private investors, to raise capital for the bank in accordance with the laws and regulations in effect at the time. The principal business purpose of the REIT was to provide an efficient and economical means to raise capital. The REIT also provided state tax benefits beginning in 2002. On December 31, 2003 the California Franchise Tax Board (FTB) announced certain tax transactions related to real estate investment trusts (REITs) and regulated investment companies (RICs) will be disallowed pursuant to Senate Bill 614 and Assembly Bill 1601, which were signed into law in the 4th quarter of 2003 (For further discussion see Income Taxes section of Results of Operations contained in this Management’s Discussion and Analysis of Financial Condition and Results of Operations).
Effective April 23, 2004, the Company completed its merger with Taft National Bank headquartered in Taft, California. Taft National Bank (“Taft”) was merged into United Security Bank and Taft’s two branches began operating as branches of United Security Bank. The total consideration paid to Taft shareholders was 241,447 shares of the Company’s common stock valued at just over approximately $6.0 million. As a result of the merger, the Company acquired $15.4 million in cash and short-term investments, $23.3 million in loans, and $48.2 million in deposits. This transaction was accounted for using the purchase accounting method, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Taft based on the fair value of those assets and liabilities. The consolidated statements of income include the operations of Taft from the date of the acquisition forward.
During August 2005, the Bank formed a new subsidiary named United Security Emerging Capital Fund (the Fund) for the purpose of providing investment capital for Low-Income Communities (LIC’s). The new subsidiary was formed as a Community Development Entity (CDE) and as such, must be certified by the Community Development Financial Institutions Fund of the United States Department of the Treasury in order to apply for New Market Tax Credits (NMTC). The Fund submitted an application to the Department of the Treasury to become certified as a CDE in August 2005 and was approved in February 2006. Subsequent to that application, the Fund submitted an application to apply for an allocation of New Market Tax Credits in September 2005. The Fund was not awarded funding from the Department of Treasury during the 2006 allocation process, but applied for the 2007 allocation of New Market Tax Credits in August 2006. The Fund was not awarded funding during the 2007 allocation process. The Fund did not apply for allocations of New Market Credits during 2007 or 2008. If the Fund’s NMTC is ever approved for the allocation of New Market Credits, the Fund can attract investments and make loans and investments in LIC’s and thereby qualify its investors to receive Federal Income Tax Credits. The maximum that can be applied for under the New Markets Tax Credit program by any one CDE is $150 million, and the Bank is subject to an investment limitation of 10% of its risk-based capital. Federal new market tax credits would be applied over a seven-year period, 5% for the first three years, and 6% for the next four years for a total of 39%.
On February 16, 2007, the Company completed its merger of Legacy Bank, N.A. with and into United Security Bank, a wholly owned subsidiary of the Company. Legacy Bank which began operations in 2003 operated one banking office in Campbell, California serving small business and retail banking clients. With its small business and retail banking focus, Legacy Bank provides a unique opportunity for United Security Bank to serve a loyal and growing small business niche and individual client base in the San Jose area. Upon completion of the merger, Legacy Bank's branch office began operating as a branch office of United Security Bank. As of February 16, 2007 Legacy Bank had net assets of approximately of $8.6 million, including net loans of approximately $62.4 million and deposits of approximately $69.6 million.
In the merger with Legacy Bank, the Company issued 976,411 shares of its stock in a tax free exchange for all of the Legacy Bank common shares. The total value of the transaction was approximately $21.7 million. The merger transaction was accounted for using the purchase accounting method, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Legacy based on the fair value of those assets and liabilities. Fair-market-value adjustments and intangible assets totaled approximately $12.9 million, including $8.8 million in goodwill. The allocations of purchase price based upon the fair market value of assets acquired and liabilities assumed were finalized during the fourth quarter of 2007.
During July 2007, the Company formed USB Capital Trust II, a wholly-owned special purpose entity, for the purpose of issuing Trust Preferred Securities. Like USB Capital Trust I formed in July 2001, USB Capital Trust II is a Variable Interest Entity (VIE) and a deconsolidated entity pursuant to FIN 46. On July 23, 2007 USB Capital Trust II issued $15 million in Trust Preferred securities. The securities have a thirty-year maturity and bear a floating rate of interest (repricing quarterly) of 1.29% over the three-month LIBOR rate (initial coupon rate of 6.65%). Interest will be paid quarterly. Concurrent with the issuance of the Trust Preferred securities, USB Capital Trust II used the proceeds of the Trust Preferred securities offering to purchase a like amount of junior subordinated debentures of the Company. The Company will pay interest on the junior subordinated debentures to USB Capital Trust II, which represents the sole source of dividend distributions to the holders of the Trust Preferred securities. The Company may redeem the junior subordinated debentures at anytime before October 2008 at a redemption price of 103.3, and thereafter each October as follows: 2008 at 102.64, 2009 at 101.98, 2010 at 101.32, 2011 at 100.66, and at par anytime after October 2012.
The Bank currently has eleven banking branches, one construction lending office, and one financial services office, which provide banking and financial services in Fresno, Madera, Kern, and Santa Clara counties. As a community-oriented bank holding company, the Company continues to seek ways to better meet its customers' needs for financial services, and to expand its business opportunities in today's ever-changing financial services environment. The Company's strategy is to be a better low-cost provider of services to its customer base while enlarging its market area and corresponding customer base to further its ability to provide those services.
Current Trends Affecting Results of Operations and Financial Position
The Company’s overall operations are impacted by a number of factors, including not only interest rates and margin spreads, which impact results of operations, but also the composition of the Company’s balance sheet. One of the primary strategic goals of the Company is to maintain a mix of assets that will generate a reasonable rate of return without undue risk, and to finance those assets with a low-cost and stable source of funds. Liquidity and capital resources must also be considered in the planning process to mitigate risk and allow for growth.
The following table summarizes the year-to-date averages of the components of interest-bearing assets as a percentage of total interest bearing assets, and the components of interest-bearing liabilities as a percentage of total interest-bearing liabilities:
| | | YTD Average | | | YTD Average | | | YTD Average | |
| | | 12/31/08 | | | 12/31/07 | | | 12/31/06 | |
| Loans | | | 84.23 | % | | | 85.00 | % | | | 80.26 | % |
| Investment securities | | | 14.30 | % | | | 13.46 | % | | | 15.65 | % |
| Interest-bearing deposits in other banks | | | 1.39 | % | | | 1.02 | % | | | 1.33 | % |
| Federal funds sold | | | 0.08 | % | | | 0.52 | % | | | 2.76 | % |
| Total earning assets | | | 100.00 | % | | | 100.00 | % | | | 100.00 | % |
| | | | | | | | | | | | | |
| NOW accounts | | | 7.92 | % | | | 8.82 | % | | | 11.21 | % |
| Money market accounts | | | 22.89 | % | | | 25.99 | % | | | 31.56 | % |
| Savings accounts | | | 7.50 | % | | | 8.79 | % | | | 8.02 | % |
| Time deposits | | | 42.51 | % | | | 50.05 | % | | | 44.72 | % |
| Other borrowings | | | 16.84 | % | | | 3.40 | % | | | 0.96 | % |
| Trust Preferred Securities | | | 2.34 | % | | | 2.95 | % | | | 3.53 | % |
| Total interest-bearing liabilities | | | 100.00 | % | | | 100.00 | % | | | 100.00 | % |
Continued deterioration in the real estate markets and the economy in general have impacted the Company’s operations during 2008 although, the Company continues its business development and expansion efforts throughout a diverse market area.
With market rates of interest declining 100 basis points during the fourth quarter of 2007, another 400 basis points during the year ended December 31, 2008, the Company has experienced significant declines in its net interest margin. The Company’s net interest margin was 4.33% for the year ended December 31, 2008, as compared to 5.35% and 5.67% for the years ended December 31, 2007 and December 31, 2006, respectively. With approximately 64.0% of the loan portfolio in floating rate instruments at December 31, 2008, the effects of market rates continue to be realized almost immediately on loan yields. Loans yielded 6.75% during the year ended December 31, 2008, as compared to 9.07% and 9.13% for the years ended December 31, 2007 and December 31, 2006, respectively. With a significant increase in nonaccrual loans during 2008, and specifically during the second half of 2008, the Company reversed approximately $1.0 million in interest income during the year, reducing the loan yield by approximately 17 basis points during the year ended December 31, 2008. Loan yield was enhanced during 2007, as a nonperforming loan was paid off during the first quarter of 2007, providing an additional $902,000 in previously unrecognized interest income that would not have otherwise been recognized during 2007, and an enhancement to loan yield of approximately 15 basis points for the year ended December 31, 2007. Although market rates of interest declined so rapidly during 2008, deposit repricing was slow to follow the decline in loan rates during the second half of 2008. However, with the recent stock market declines, combined with more substantial FDIC insurance coverage, deposit rates have begun to decline as investors have sought safety in bank deposits. Borrowing rates have declined significantly during the fourth quarter of 2008, resulting in overnight and short-term borrowing rates of less than 0.50% at December 31, 2008. The Company has benefited from these rate declines, as it has utilized overnight and short-term borrowing lines through the Federal Reserve and Federal Home Loan Bank to a greater degree during 2008. The Company’s average cost of funds was 2.75% for the year ended December 31, 2008 as compared to 3.91% and 3.24% for the years ended December 31, 2007 and 2006, respectively.
Total noninterest income of $8.3 million reported for the year ended December 31, 2008 decreased $1.3 million or 13.7% as compared to the year ended December 31, 2007, primarily as the result of reductions of approximately $1.1 million in SFAS No. 159 fair market value gains between the two twelve-month periods on the Company’s junior subordinated debt. Noninterest income continues to be driven by customer service fees, which totaled $4.7 million for the year ended December 31, 2008, representing a modest decline of $134,000 or 2.8% over the $4.8 million in customer service fees reported for the year ended December 31, 2007, but an increase of $877,000 or 23.2% over the noninterest income of $3.8 million reported for the year ended December 31, 2006. Customer service fees represented 55.8%, 49.6%, and 41.8% of total noninterest income for the years ended December 31, 2008, 2007, and 2006, respectively. Shared appreciation income on lending activities, while not a consistent income stream, did increase approximately $223,000 between the years ended December 31, 2008 and December 31, 2007.
Noninterest expense increased approximately $547,000 or 2.4% between the years ended December 31, 2007 and December 31, 2008, and increased $3.3 million or 16.8% between the years ended December 31, 2006 and December 31, 2008. Reductions in salary expense, data processing, and professional fees, were more than offset by impairment losses on other real estate owned through foreclosure (OREO) and intangible assets. Impairment losses on the Company’s intangible assets totaled $648,000 and impairment charges on OREO properties totaled another $887,000 during the year ended December 31, 2008. Salary expense decreased $220,000 or 2.0% between the years ended December 31, 2007 and December 31, 2008 due in large part to significant decreases in bonus and incentive expenses during 2008. Professional fees declined $329,000 or 18.2% between the years ended December 31, 2007 and December 31, 2008 as the result of reductions in corporate legal fees between the two periods.
During both the third and fourth quarters of 2008, the Company’s Board of Directors declared a one-percent (1%) stock dividend on the Company’s outstanding common stock. The stock dividends for the third and fourth quarters of 2008 replace the normal quarterly cash dividends and reflect a similar value. Although the Company's capital position remains strong, the change in the dividend from cash to stock was employed as a precaution against uncertainties in the current economic environment, and specifically the real estate1-4 family residential real estate market which has had an impact on the Company's construction and related land and lot loan portfolio. The Company believes, given the current uncertainties in the economy and unprecedented declines in real estate valuations in our markets, it is prudent to retain capital in this environment, and better position the Company for future growth opportunities. Based upon the number of outstanding common shares on the respective record dates, an additional 117,732 and 118,449 shares were issued to shareholders during October 2008 and January 2009, respectively. For purposes of earnings per share calculations, the Company’s weighted average shares outstanding and potentially dilutive shares used in the computation of earnings per share have been restated after giving retroactive effect to the 1% stock dividends to shareholders for all periods presented.
The Company has sought to maintain a strong, yet conservative balance sheet during the year ended December 31, 2008. Total assets of $761.1 million at December 31, 2008 decreased approximately $10.6 million during the year ended December 31, 2008, with decreases of $48.2 million in gross loans, offset by increases of $23.5 million other real estate owned through foreclosure, and increases of $20.9 million in investments and interest-bearing deposits in other banks. Approximately half of the decline in loans experienced during 2008 was the result of OREO properties that were transferred from the loan portfolio in settlement of loan obligations, the majority of which were transferred during the fourth quarter of 2008. The most significant declines in loan balances experienced during 2008 were in construction loans which decreased $58.4 million or 32.8% and in real estate mortgage loans which decreased $15.9 million or 11.1% between December 31, 2007 and December 31, 2008. On average, loan volume remained stable between 2008 and 2007, with loans averaging $587.9 million or 89.7% of average earning assets for the year ended December 31, 2008 as compared to $580.9 million or 89.4% of average earning assets for the year ended December 31, 2007.
Deposits of $508.5 million at December 31, 2008 declined $126.1 million or 19.9% during the year ended December 31, 2008 primarily as the result of a decline in brokered time deposits, and deposits obtained from the State of California. As part of its asset/liability strategy, the Company chose to let brokered time deposits mature during 2008, and to use alternative lower-cost funding sources including FHLB term advances and overnight borrowings from the Federal Reserve. This strategy has worked well for the Company during 2008 and helped to reduce funding costs significantly, although the Company will seek to attract additional deposits during 2009 as they continue to become less expensive, relative to wholesale funding sources. Wholesale borrowings, including FHLB advances and Federal Reserve overnight borrowings, increased $122.8 million during 2008 to a balance of $155.0 million at December 31, 2008. The average cost of those wholesale borrowings was 2.32% and 5.17% for the years ended December 31, 2008 and December 31, 2007, representing a cost reduction of 285 basis points between the two twelve-month periods. Although the Company has realized significant interest expense reductions by utilizing these borrowing lines, the use of such lines are monitored closely to ensure sound balance sheet management in light of the current economic and credit environment.
The cost of the Company’s subordinated debentures issued by USB Capital Trust II has declined significantly as market rates of interest have fallen during the year ended December 31, 2008. With pricing at 3-month-LIBOR plus 129 basis points, the effective cost of the subordinated debt was 2.73% at December 31, 2008, representing a rate reduction of 326 basis points between December 31, 2007 and December 31, 2008. As a result of interest rate changes experienced during 2008 in relation to market spreads for junior subordinated debentures, the Company recorded an additional $1.4 million pretax fair value gain on its junior subordinated debt bringing the total cumulative gain recorded on the debt to $3.7 million at December 31, 2008.
Nonperforming assets increased significantly during the second half of 2008 as real estate markets continue to suffer from the mortgage crisis which began during mid-2007. Nonaccrual loans totaled $51.1 million at December 31, 2008, representing an increase of $29.5 million as compared to the balance of $21.6 million reported at December 31, 2007. The increase in nonaccrual loans experienced during 2008 is comprised largely of construction and real estate development loans. In determining the adequacy of the underlying collateral related to theses loans, management monitors trends within specific geographical areas, loan-to-value ratios, appraisals, and other credit issues related to the specific loans. During the later part of 2008, the Company successfully worked with many of its borrowers to re-margin loans as collateral values declined, then weakening the Company’s credit position and increasing the potential for losses. Impaired loans of $54.4 million at December 31, 2008 increased $33.7 million during the year ended December 31, 2008 and increased $716,000 during the fourth quarter of 2008. Classified loans (comprised of the total of nonaccrual, impaired, and substandard loans) totaled $88.1 million at December 31, 2008, representing an increase of $36.4 million from the balance of $51.8 million reported at December 31, 2007, but a decrease of $17.0 million from the balance of $105.1 million reported at September 30, 2008. The decrease in classified loans experienced during the fourth quarter of 2008 is primarily the result of more than $23.0 in nonaccrual loans that were transferred to OREO during that quarter. Other real estate owned through foreclosure increased $23.5 million between December 31, 2007 and December 31, 2008, as five properties were moved through foreclosure proceedings during the first nine months of 2008, and an additional nine properties were moved during the fourth quarter of 2008, when all other means of collection failed. One of those foreclosed properties totaling $1.6 million was subsequently sold during the second quarter of 2008. As a result of these events, nonperforming assets as a percentage of total assets increased from 3.66% at December 31, 2007 to 10.68% at December 31, 2008.
Management continues to monitor economic conditions in the real estate market for signs of further deterioration or improvement which may impact the level of the allowance for loan losses required to cover identified losses in the loan portfolio. Increased charge-offs and additional loan loss provisions made during the year ended December 31, 2008 impacted earnings during much of 2008, but the provisions made to the allowance for credit loses, totaling $265,000, $548,000, $6.4 million, and $2.4 million during the first, second, third, and fourth quarters of 2008, respectively, are adequate to cover inherent losses in the loan portfolio. Loan and lease net charge-offs totaled $5.4 million for the year ended December 31, 2008 as compared to net charge-offs of $4.4 million and $263,000 for the years ended December 31, 2007 and December 31, 2006, respectively.
The Company continues to emphasize relationship banking and core deposit growth, and has focused greater attention on its market area of Fresno, Madera, and Kern Counties, as well as Campbell, in Santa Clara County. The San Joaquin Valley and other California markets have shown weaker demand for construction lending and commercial lending from small and medium size businesses, as commercial and residential real estate markets declined during 2007 and throughout 2008. The year ended December 31, 2008 has presented significant challenges for the banking industry with tightening credit markets, weakening real estate markets, and increased loan losses adversely affecting the industry.
The Company continually evaluates its strategic business plan as economic and market factors change in its market area. Growth and increasing market share will be of primary importance during 2009 and beyond. The banking industry is currently experiencing continued pressure on net margins as well as asset quality resulting from conditions in the sub-prime real estate market, and a general deterioration in credit markets. As a result, market rates of interest and asset quality will continue be an important factor in the Company’s ongoing strategic planning process.
Application of Critical Accounting Policies and Estimates
The Company’s consolidated financial statements are prepared in accordance with generally accepted accounting principles and follow general practices within the industry in which it operates. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Certain policies inherently have a greater reliance on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. Estimates, assumptions, and judgments are necessary when assets and liabilities are required to be recorded at fair value, when a decline in the value of an asset not carried on the financial statements at fair value warrants an impairment write-down or valuation reserve to be established, or when an asset or liability needs to be recorded contingent upon a future event. Carrying assets and liabilities at fair value inherently results in more financial statement volatility. The fair values and the information used to record valuation adjustments for certain assets and liabilities are based either on quoted market prices or are provided by other third-party sources, when available. When third-party information is not available, valuation adjustments are estimated using the Company’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.
The most significant accounting policies followed by the Company are presented in Note 1 to the Company’s consolidated financial statements included herein. These policies, along with the disclosures presented in the other financial statement notes and in this financial review, provide information on how significant assets and liabilities are valued in the financial statements and how those values are determined. Based on the valuation techniques used and the sensitivity of financial statement amounts to the methods, assumptions, and estimates underlying those amounts, management has identified the determination of the allowance for loan losses, other real estate owned through foreclosure, impairment of collateralized mortgage obligations and other investment securities, and fair value estimates on junior subordinated debt to be accounting areas that require the most subjective or complex judgments, and as such could be most subject to revision as new information becomes available.
Allowance for Credit Losses
The allowance for credit losses represents management's estimate of probable credit losses inherent in the loan portfolio. Determining the amount of the allowance for credit losses is considered a critical accounting estimate because it requires significant judgment and the use of estimates related to the amount and timing of expected future cash flows on impaired loans, estimated losses on pools of homogeneous loans based on historical loss experience, and consideration of current economic trends and conditions, all of which may be susceptible to significant change. The loan portfolio also represents the largest asset type on the consolidated balance sheet. Note 1 to the consolidated financial statements describes the methodology used to determine the allowance for credit losses and a discussion of the factors driving changes in the amount of the allowance for credit losses is included in the Asset Quality and Allowance for Credit Losses section of this financial review.
If the loan portfolio were to increase by 10% proportionally throughout all loan classifications, the additional estimated provision to the allowance that would be required, based on the percentage loss allocations utilized at December 31, 2008, would be approximately $1.5 million pretax ($865,000 net of tax, or $0.07 per share basic and diluted). This estimate is comprised of an additional $1.1 million ($660,000 net of tax, or $0.05 per share basic and diluted) for criticized loans (those classified as special mention or worse and excluding those considered impaired under SFAS No. 114), and an additional $355,000 ($206,000 net of tax, or $0.02 per share basic and diluted) for the remainder of the loan portfolio that is performing.
Other Real Estate Owned
Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value of the property, less estimated costs to sell. The excess, if any, of the loan amount over the fair value of the collateral is charged to the allowance for credit losses. The determination of fair value is generally based upon pre-approved, external appraisals. As real estate markets declined during 2008 and essentially became illiquid in many areas, Management was required to use additional judgment in determining the factors associated with fair value of the real estate, including the term over which the properties could be disposed in an orderly liquidation. This became necessary as many appraisals were based upon comparable sales which were deeply discounted forced liquidations or bulk sales caused by the severity of the housing crises. Subsequent declines in the fair value of other real estate owned, along with related revenue and expenses from operations, are charged to noninterest expense. The fair market valuation of such properties is based upon estimates, and as such, is subject to change as circumstances in the Company’s market area, or general economic trends, change.
Impairment of Investment Securities
Investment securities classified as available for sale (“AFS”) are carried at fair value and the impact of changes in fair value are recorded on the Company’s consolidated balance sheet as an unrealized gain or loss in “Accumulated other comprehensive income (loss),” a separate component of shareholders’ equity. Securities classified as AFS or held to maturity (“HTM”) are subject to review to identify when a decline in value is other than temporary. Factors considered in determining whether a decline in value is other than temporary include: whether the decline is substantial; the duration of the decline; the reasons for the decline in value; whether the decline is related to a credit event or to a change in interest rate; our ability and intent to hold the investment for a period of time that will allow for a recovery of value; and the financial condition and near-term prospects of the issuer. When it is determined that a decline in value is other than temporary, the carrying value of the security is reduced to its estimated fair value, with a corresponding charge to earnings. At December 31, 2008, the Company held three private-label collateralized mortgage obligations (CMO’s) with an amortized cost of $17.6 million and carrying value of $12.8 million. Impairment analysis on these three CMO’s was performed utilizing the services of a third-party investment broker specializing in private-label CMO’s, and was based upon estimated cash flows. Estimated cash flows were based upon assumptions of future prepayments and default rates, and thus may be subject to revision as events change in the future. At December 31, 2008, the Company did not have any investment securities considered other than temporarily impaired.
Fair Value
Effective January 1, 2007, the Company adopted SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, and SFAS No. 157, Fair Value Measurements, choosing to apply the pronouncement to its junior subordinated debt. SFAS No 157 defines how applicable assets and liabilities are to be valued, and requires expanded disclosures about financial instruments carried at fair value. SFAS No. 157 establishes a hierarchical disclosure framework associated with the level of pricing observability utilized in measuring financial instruments at fair value. The degree of judgment utilized in measuring the fair value of financial instruments generally correlates to the level of pricing observability. Financial instruments with readily available active quoted prices or for which fair value can be measured from actively quoted prices generally will have a higher degree of pricing observability and a lesser degree of judgment utilized in measuring fair value. Conversely, financial instruments infrequently traded or not quoted in an active market will generally have little or no pricing observability and a higher degree of judgment utilized in measuring fair value. Pricing observability is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established and the characteristics specific to the transaction. Determining fair values under SFAS No. 157 may include judgments related to measurement factors that may vary from actual transactions executed in the marketplace. For the year ended December 31, 2008, the Company recorded fair value gains related to its junior subordinated debt totaling $1.4 million. (See Notes 10 an 15 of the Notes to Consolidated Financial Statements for additional information about financial instruments carried at fair value.)
Goodwill
Business combinations involving the Company’s acquisition of the equity interests or net assets of another enterprise or the assumption of net liabilities in an acquisition of branches constituting a business may give rise to goodwill. The acquisition of Taft National Bank during April 2004 gave rise to goodwill totaling approximately $1.6 million, and the recent acquisition of Legacy Bank resulted in goodwill of approximately $8.8 million. Goodwill represents the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed in transactions accounted for under the purchase method of accounting. The value of goodwill is ultimately derived from the Company’s ability to generate net earnings after the acquisition. A decline in net earnings could be indicative of a decline in the fair value of goodwill and result in impairment. For that reason, goodwill is assessed for impairment at a reporting unit level at least annually using an internal cash flow model. While the Company believes all assumptions utilized in its assessment of goodwill for impairment are reasonable and appropriate, changes in earnings, the effective tax rate, historical earnings multiples and the cost of capital could all cause different results for the calculation of the present value of future cash flows.
Income Taxes
Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities. Deferred taxes are measured using current tax rates applied to such taxable income in the years in which those temporary differences are expected to be recovered. If the Company’s future income is not sufficient to apply the deferred tax assets within the tax years to which they may be applied, the deferred tax asset may not be realized and the Company’s income will be reduced.
On January 1, 2007 the Company adopted Financial Accounting Standards Board (FASB) Interpretation 48 (FIN 48), “Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109”. FIN 48 clarifies SFAS No. 109, “Accounting for Income Taxes”, to indicate a criterion that an individual tax position would have to meet for some or all of the income tax benefit to be recognized in a taxable entity’s financial statements. Under the guidelines of FIN48, an entity should recognize the financial statement benefit of a tax position if it determines that it is more likely than not that the position will be sustained on examination. The term “more likely than not” means a likelihood of more than 50 percent.” In assessing whether the more-likely-than-not criterion is met, the entity should assume that the tax position will be reviewed by the applicable taxing authority.
The Company reviewed its various tax positions, including its ongoing REIT case with the California Franchise Tax Board (FTB), as of January 1, 2007 (adoption date), and then again each subsequent quarter thereafter in light of the adoption of FIN48. The Bank, with guidance from advisors believes the case related to consent dividends taken by the Bank’s REIT during 2002 has merit with regard to points of law, and that the tax law at the time allowed for the deduction of the consent dividend. However, the Bank, with the concurrence of advisors, cannot conclude that it is “more than likely” (as defined in FIN48) that the Bank will prevail in its case with the FTB. As a result of this determination, effective January 1, 2007 the Company recorded an adjustment of $1,298,470 to beginning retained earnings upon adoption of FIN48 to recognize the potential tax liability under the guidelines of the interpretation. The adjustment includes amounts for assessed taxes, penalties, and interest. During the years ended December 31, 2008 and 2007, the Company increased the unrecognized tax liability by an additional $87,421 and $87,091, respectively, in interest for the period, bringing the total recorded tax liability under FIN48 to $1,472,992 and $1,385,561 at December 31, 2008 and December 31, 2007, respectively. It is the Company’s policy to recognize interest and penalties under FIN48 as a component of income tax expense.
Pursuant to FIN 48, the Company will continue to re-evaluate existing tax positions, as well as new positions as they arise. If the Company determines in the future that its tax positions are not “more likely than not” to be sustained (as defined) by taxing authorities, the Company may need to recognize additional tax liabilities.
Revenue recognition
The Company’s primary sources of revenue are interest income from loans and investment securities. Interest income is generally recorded on an accrual basis, unless the collection of such income is not reasonably assured or cannot be reasonably estimated. Pursuant to SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases”, nonrefundable fees and costs associated with originating or acquiring loans are recognized as a yield adjustment to the related loans by amortizing them into income over the term of the loan using a method which approximates the interest method. Other credit-related fees, such as standby letter of credit fees, loan placement fees and annual credit card fees are recognized as noninterest income during the period the related service is performed.
For loans placed on nonaccrual status, the accrued and unpaid interest receivable may be reversed at management's discretion based upon management's assessment of collectibility, and interest is thereafter credited to principal to the extent necessary to eliminate doubt as to the collectibility of the net carrying amount of the loan.
Results of Operations
For the year ended December 31, 2008, the Company reported net income of $4.1 million or $0.34 per share ($0.34 diluted) as compared to $11.3 million or $0.93 per share ($0.92 diluted) for the year ended December 31, 2007, and $13.4 million or $1.15 per share ($1.14 diluted) for the year ended December 31, 2006. Net income decreased $7.2 million between December 31, 2007 and December 31, 2008 as the result of increased provisions for credit losses taken during the third and fourth quarters, combined with significant declines in market rates of interest. Net income for 2007 decreased $2.1 million from the previous year as the result of additional loan loss provisions taken during the fourth quarter, which more than offset increased net interest income realized from increased volume in earning assets.
The Company’s return on average assets was 0.52 % for the year ended December 31, 2008 as compared to 1.47 % and 2.04 % for the same twelve-month periods of 2007 and 2006, respectively. The Company’s return on average equity was 4.93% for the year ended December 31, 2008 as compared to 13.73 % and 20.99 % for the same twelve-month periods of 2007 and 2006, respectively. Declines in the return on average assets and average equity experienced by the Company during 2008 were primarily the result of decreasing net interest margins, and additional loan loss provisions taken during the year.
Net Interest Income
Net interest income, the most significant component of earnings, is the difference between the interest and fees received on earning assets and the interest paid on interest-bearing liabilities. Earning assets consist primarily of loans, and to a lesser extent, investments in securities issued by federal, state and local authorities, and corporations, as well as interest-bearing deposits and overnight funds with other financial institutions. These earning assets are funded by a combination of interest-bearing and noninterest-bearing liabilities, primarily customer deposits and short-term and long-term borrowings.
Net interest income before provision for credit losses totaled $30.2 million for the year ended December 31, 2008 as compared to $36.6 million for the year ended December 31, 2007, and $33.2 million for the year ended December 31, 2006. This represents a decrease of $6.4 million or 17.4 % between the years ended December 31, 2007 and 2008, as compared to an increase of $3.4 million or 10.3% between 2006 and 2007. The decrease in net interest income between 2007 and 2008 is primarily the result of decreased yields on interest-earning assets, which more than offset the decreased yields on interest-bearing liabilities. The increase in net interest income between 2006 and 2007 is the result of increased volume in earning assets which more than outweighed rate and volume increases experienced in interest-bearing liabilities.
Table 1. – Distribution of Average Assets, Liabilities and Shareholders’ Equity:
Interest rates and interest differentials
Years Ended December 31, 2008, 2007, and 2006
| | | | | | 2008 | | | | | | | | | 2007 | | | | | | | | | 2006 | | | | |
| | | Average | | | | | | Yield/ | | | Average | | | | | | Yield/ | | | Average | | | | | | Yield/ | |
| | Balance | | | Interest | | | Rate | | | Balance | | | Interest | | | Rate | | | Balance | | | Interest | | | Rate | |
| Assets: | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-earning assets: | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Loans (1) | | $ | 587,925 | | | $ | 39,669 | | | | 6.75 | % | | $ | 580,873 | | | $ | 52,690 | | | | 9.07 | % | | $ | 469,959 | | | $ | 42,902 | | | | 9.13 | % |
| Investment Securities – taxable | | | 98,330 | | | | 5,170 | | | | 5.26 | % | | | 89,765 | | | | 3,896 | | | | 4.34 | % | | | 89,378 | | | | 3,254 | | | | 3.64 | % |
| Investment Securities – nontaxable (2) | | | 1,452 | | | | 68 | | | | 4.68 | % | | | 2,227 | | | | 108 | | | | 4.85 | % | | | 2,226 | | | | 108 | | | | 4.85 | % |
| Interest on deposits in other banks | | | 9,680 | | | | 222 | | | | 2.29 | % | | | 7,001 | | | | 271 | | | | 3.87 | % | | | 7,771 | | | | 324 | | | | 4.17 | % |
| Federal funds sold and reverse repos | | | 549 | | | | 18 | | | | 3.28 | % | | | 3,527 | | | | 191 | | | | 5.42 | % | | | 16,166 | | | | 768 | | | | 4.75 | % |
| Total interest-earning assets | | | 697,936 | | | $ | 45,147 | | | | 6.47 | % | | | 683,393 | | | $ | 57,156 | | | | 8.36 | % | | | 585,500 | | | $ | 47,356 | | | | 8.09 | % |
| Allowance for possible credit losses | | | (12,269 | ) | | | | | | | | | | | (9,787 | ) | | | | | | | | | | | (8,067 | ) | | | | | | | | |
| Noninterest-bearing assets: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Cash and due from banks | | | 20,785 | | | | | | | | | | | | 25,255 | | | | | | | | | | | | 26,426 | | | | | | | | | |
| Premises and equipment, net | | | 14,981 | | | | | | | | | | | | 15,899 | | | | | | | | | | | | 12,706 | | | | | | | | | |
| Accrued interest receivable | | | 2,779 | | | | | | | | | | | | 4,061 | | | | | | | | | | | | 3,597 | | | | | | | | | |
| Other real estate owned | | | 9,434 | | | | | | | | | | | | 3,187 | | | | | | | | | | | | 3,354 | | | | | | | | | |
| Other assets | | | 44,237 | | | | | | | | | | | | 42,326 | | | | | | | | | | | | 32,570 | | | | | | | | | |
| Total average assets | | $ | 777,883 | | | | | | | | | | | $ | 764,334 | | | | | | | | | | | $ | 656,086 | | | | | | | | | |
| Liabilities and Shareholders' Equity: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| NOW accounts | | $ | 42,988 | | | $ | 223 | | | | 0.52 | % | | $ | 46,382 | | | $ | 292 | | | | 0.63 | % | | $ | 49,118 | | | $ | 286 | | | | 0.58 | % |
| Money market accounts | | | 124,202 | | | | 2,963 | | | | 2.39 | % | | | 136,720 | | | | 4,246 | | | | 3.11 | % | | | 138,242 | | | | 3,701 | | | | 2.68 | % |
| Savings accounts | | | 40,699 | | | | 482 | | | | 1.18 | % | | | 46,225 | | | | 883 | | | | 1.91 | % | | | 35,135 | | | | 198 | | | | 0.56 | % |
| Time deposits | | | 230,746 | | | | 8,420 | | | | 3.65 | % | | | 263,196 | | | | 12,993 | | | | 4.94 | % | | | 195,922 | | | | 8,412 | | | | 4.29 | % |
| Other borrowings | | | 91,368 | | | | 2,116 | | | | 2.32 | % | | | 17,891 | | | | 925 | | | | 5.17 | % | | | 4,209 | | | | 223 | | | | 5.30 | % |
| Trust Preferred securities | | | 12,710 | | | | 734 | | | | 5.77 | % | | | 15,537 | | | | 1,234 | | | | 7.94 | % | | | 15,464 | | | | 1,355 | | | | 8.76 | % |
| Total interest-bearing liabilities | | | 542,713 | | | $ | 14,938 | | | | 2.75 | % | | | 525,951 | | | $ | 20,573 | | | | 3.91 | % | | | 438,090 | | | $ | 14,175 | | | | 3.24 | % |
| Noninterest-bearing liabilities: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Noninterest-bearing checking | | | 144,772 | | | | | | | | | | | | 146,954 | | | | | | | | | | | | 146,722 | | | | | | | | | |
| Accrued interest payable | | | 1,131 | | | | | | | | | | | | 2,207 | | | | | | | | | | | | 2,021 | | | | | | | | | |
| Other liabilities | | | 6,782 | | | | | | | | | | | | 7,221 | | | | | | | | | | | | 5,615 | | | | | | | | | |
| Total average liabilities | | | 695,398 | | | | | | | | | | | | 682,333 | | | | | | | | | | | | 592,448 | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Total average shareholders' equity | | | 82,485 | | | | | | | | | | | | 82,001 | | | | | | | | | | | | 63,638 | | | | | | | | | |
| Total average liabilities and | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Shareholders' equity | | $ | 777,883 | | | | | | | | | | | $ | 764,334 | | | | | | | | | | | $ | 656,086 | | | | | | | | | |
| Interest income as a percentage | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| of average earning assets | | | | | | | | | | | 6.47 | % | | | | | | | | | | | 8.36 | % | | | | | | | | | | | 8.09 | % |
| Interest expense as a percentage | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| of average earning assets | | | | | | | | | | | 2.14 | % | | | | | | | | | | | 3.01 | % | | | | | | | | | | | 2.42 | % |
| Net interest margin | | | | | | | | | | | 4.33 | % | | | | | | | | | | | 5.35 | % | | | | | | | | | | | 5.67 | % |
| (1) | Loan amounts include nonaccrual loans, but the related interest income has been included only if collected for the period prior to the loan being placed on a nonaccrual basis. Loan interest income includes loan fees of approximately $3,074,000, $3,076,000, and $3,536,000 for the years ended December 31, 2008, 2007, and 2006, respectively. |
| (2) | Applicable nontaxable securities yields have not been calculated on a tax-equivalent basis because they are not material to the Company’s results of operations. |
As summarized in Table 2, the increase in net interest income between the two twelve-month periods ended December 31, 2008 and 2007 is comprised of a decrease in total interest income of approximately $12.0 million, which was only partially offset by a decrease in total interest expense of approximately $5.6 million. The Bank's net interest margin, as shown in Table 1, decreased to 4.33% at December 31, 2008 from 5.35% at December 31, 2007, a decrease of 102 basis points (100 basis points = 1%) between the two periods. The net margin of 5.35% reported during 2007 represents a decrease of 32 basis points from the 5.67% net margin realized by the Company during 2006. While average assets have grown over the past three years and the balance sheet mix has changed, interest rate movements over those three years have played a significant role in net interest income trends. As a result of changes in market rates of interest, the prime rate averaged 5.09% for the year ended December 31, 2008 as compared to 8.05% and 7.96% for the years ended December 31, 2007 and 2006, respectively.
Both the Company's net interest income and net interest margin are affected by changes in the amount and mix of interest-earning assets and interest-bearing liabilities, referred to as "volume change." Both are also affected by changes in yields on interest-earning assets and rates paid on interest-bearing liabilities, referred to as "rate change." The following table sets forth the changes in interest income and interest expense for each major category of interest-earning asset and interest-bearing liability, and the amount of change attributable to volume and rate changes for the years indicated. Changes in interest income and expense, which are not attributable specifically to either rate or volume, are allocated proportionately between the two variances based on the absolute dollar amounts of the change in each.
Table 2. Rate and Volume Analysis
| | | 2008 compared to 2007 | | | 2007 compared to 2006 | |
| (In thousands) | | Total | | | Rate | | | Volume | | | Total | | | Rate | | | Volume | |
| Increase (decrease) in interest income: | | | | | | | | | | | | | | | | | | |
| Loans | | $ | (13,021 | ) | | $ | (13,660 | ) | | $ | 639 | | | $ | 9,788 | | | $ | (275 | ) | | $ | 10,063 | |
| Investment securities | | | 1 ,234 | | | | 906 | | | | 328 | | | | 642 | | | | 628 | | | | 14 | |
| Interest-bearing deposits in other banks | | | (49 | ) | | | (84 | ) | | | 35 | | | | (53 | ) | | | (25 | ) | | | (28 | ) |
Federal funds sold and securities purchased under agreements to resell | | | (173 | ) | | | (36 | ) | | | (137 | ) | | | (577 | ) | | | 95 | | | | (672 | ) |
| Total interest income | | $ | (12,009 | ) | | | (12,874 | ) | | | 865 | | | | 9,800 | | | | 423 | | | | 9,377 | |
| Increase (decrease) in interest expense: | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest-bearing demand accounts | | | (1,352 | ) | | | (909 | ) | | | (443 | ) | | | 551 | | | | 643 | | | | (92 | ) |
| Savings accounts | | | (401 | ) | | | (290 | ) | | | (111 | ) | | | 685 | | | | 605 | | | | 80 | |
| Time deposits | | | (4,573 | ) | | | (3,598 | ) | | | (975 | ) | | | 4,581 | | | | 1,391 | | | | 3,190 | |
| Other borrowings | | | 1,191 | | | | (826 | ) | | | 2,017 | | | | 702 | | | | (6 | ) | | | 708 | |
| Trust Preferred securities | | | (500 | ) | | | (262 | ) | | | (238 | ) | | | (121 | ) | | | (127 | ) | | | 6 | |
| Total interest expense | | | (5,635 | ) | | | (5,885 | ) | | | 250 | | | | 6,398 | | | | 2,506 | | | | 3,892 | |
| Increase (decrease) in net interest income | | $ | (6,374 | ) | | $ | (6,989 | ) | | $ | 615 | | | $ | 3,402 | | | $ | (2,083 | ) | | $ | 5,485 | |
Total interest income decreased approximately $12.0 million or 21.0% between the years ended December 31, 2007 and 2008, and is attributable primarily to significant declines in market rates of interest resulting in decreased net interest margins, which outweighed minor increases experienced in average earning assets. Loans were most adversely impacted by yield declines as approximately two-thirds of the loan portfolio is comprised of floating rate instruments.
Total interest expense decreased approximately $5.6 million between the years ended December 31, 2007 and 2008, primarily as a result of decreased rates paid on deposit accounts and other borrowings as market rates of interest continued to decline throughout most of 2008. Rates paid on interest-bearing liabilities decreased in all categories, with the greatest decreases experienced in time deposits, borrowings through the FHLB and the FRB, and the Company’s junior subordinated debt. The Company’s interest-bearing liability mix changed during 2008 with declines in average deposit accounts, especially time deposits, which was more than offset by increases in the average volume of other borrowings including FHLB advances and overnight borrowings from the Federal Reserve. On average, time deposits decreased $32.5 million, interest-bearing demand accounts decreased by $15.9 million, and savings accounts decreased by $5.5 million between the years ended December 31, 2007 and December 31, 2008. The decrease in average deposits was more than offset by increases of more than $73.5 million in other borrowings between the years ended December 31, 2007 and December 31, 2008.
Total interest income increased approximately $9.8 million or 20.7% between the years ended December 31, 2006 and 2007, and was attributable primarily to increase in earning asset volume, as well as the yields on those earning assets to a lesser degree. Earning asset growth was almost exclusively in loans, with minimal growth in investments. On average, loans grew by approximately $111.0 million between 2006 and 2007. The Company continues to maintain a high percentage of loans in its earning asset mix with loans averaging 85.0% of total earning assets for the year ended December 31, 2007, as compared to 80.3% and 72.5% for the years ended December 31, 2006 and 2005, respectively.
Total interest expense increased approximately $6.4 million between the years ended December 31, 2006 and 2007, both as a result of increased volumes in time deposits and other borrowings, as well as increased rates paid on deposit accounts as deposit rates continued to rise throughout much of 2007. Deposit rates began to decline during the fourth quarter of 2007 as market rates of interest declined as a result of the Federal Reserves’ actions to protect a faltering economy. Between the years ended December 31, 2007 and December 31, 2006, rates paid on interest-bearing liabilities increased in all categories except other borrowing and junior subordinated debt, with the greatest increases experienced in time deposits, money market deposits, and savings accounts. The increases experienced in savings account rates during 2007 were largely the result of more than $25.0 million in savings accounts purchased with Legacy Bank during February 2007, many of which carried high preferential interest rates. Some of those savings accounts have been closed, and the Company has been able to reduce the cost of the remaining accounts as the preferential rate terms of the savings accounts expired.
Provision for Credit Losses
Provisions for credit losses and the amount added to the allowance for credit losses is determined on the basis of management's continuous credit review of the loan portfolio, consideration of past loan loss experience, current and future economic conditions, and other pertinent factors. Such factors consider the allowance for credit losses to be adequate when it covers estimated losses inherent in the loan portfolio. Based on the condition of the loan portfolio, management believes the allowance is sufficient to cover risk elements in the loan portfolio. For the year ended December 31, 2008 the provision to the allowance for credit losses amounted to $9.6 million as compared to $5.7 million and $880,000 for the years ended December 31, 2007 and 2006, respectively.
Increases in the provision to the allowance for credit losses during 2008, including provisions of $6.4 million and $2.4 million in the third and fourth quarters of 2008, respectively, were the result of higher levels of nonperforming loans during the year, and general deterioration in the housing and credit markets which began during the later part of 2007, and continued throughout 2008.
As with 2008, increases in the provision to the allowance for credit losses during 2007 included larger provisions during the third and fourth quarters of the year as the economy and the banking industry began to realize the full impact of the weakened housing and credit markets during the later part of 2007. Provisions of $2.0 million and $3.3 million were made in the third and fourth quarters of 2007. The amount provided to the allowance for credit losses during 2008 brought the allowance to 2.75% of net outstanding loan balances at December 31, 2008, as compared to 1.83% of net outstanding loan balances at December 31, 2007, and 1.68% at December 31, 2006.
Noninterest Income
The following table summarizes significant components of noninterest income for the years indicated and the net changes between those years:
| | | Years Ended December 31, | | | Increase (decrease) during Year | |
| (In thousands) | | 2008 | | | 2007 | | | 2006 | | | 2008 | | | 2007 | |
| Customer service fees | | $ | 4,656 | | | $ | 4,790 | | | $ | 3,779 | | | $ | (134 | ) | | $ | 1,011 | |
| Gain on disposition of securities | | | 24 | | | | 0 | | | | 27 | | | | 24 | | | | (27 | ) |
| Gain (loss) on sale of OREO | | | 67 | | | | 209 | | | | 50 | | | | (142 | ) | | | 159 | |
| Proceeds from life insurance | | | 0 | | | | 483 | | | | 482 | | | | (483 | ) | | | 1 | |
| Gain (loss) on swap ineffectiveness | | | 9 | | | | 66 | | | | (75 | ) | | | (57 | ) | | | 141 | |
| Gain on fair value option of financial liabilities | | | 1,363 | | | | 2,504 | | | | 0 | | | | (1,141 | ) | | | 2,504 | |
| Gain on sale of investment | | | 0 | | | | 0 | | | | 1,877 | | | | — | | | | (1,877 | ) |
| Gain (loss) on sale of fixed assets | | | (4 | ) | | | 2 | | | | 1,018 | | | | (6 | ) | | | (1,016 | ) |
| Shared appreciation income | | | 265 | | | | 42 | | | | 567 | | | | 223 | | | | (525 | ) |
| Other | | | 1,963 | | | | 1,568 | | | | 1,306 | | | | 395 | | | | 262 | |
| Total | | $ | 8,343 | | | $ | 9,664 | | | $ | 9,031 | | | $ | (1,321 | ) | | $ | 633 | |
Noninterest income consists primarily of fees and commissions earned on services that are provided to the Company’s banking customers and, to a lesser extent, gains on sales of Company assets and other miscellaneous income. Noninterest income for the year ended December 31, 2008 decreased $1.3 million or 13.7% when compared to the previous year, and decreased $688,000 or 7.6% when compared to the year ended December 31, 2006. Decreases in noninterest income experienced during 2008 were primarily the result of a decrease SFAS No. 157 fair value gains recorded on the Company’s junior subordinated debt, as well as an employee death-benefit payment received during 2007 that did not occur again during 2008. The gain on disposition of securities totaling $24,000 during 2008 was the result of an early call on municipal bonds with an amortized cost of approximately $940,000. The municipal bonds were redeemed at face value, resulting in a recognized gain on the remaining unaccreted discount.
Customer service fees continue to provide a substantial part of noninterest income over the three years presented. Customer service fees decreased $134,000 between the years ended December 2007 and December 31, 2008, which is attributable almost exclusively to decreases in ATM fee income. Increases of $1.0 million in customer service fees between 2006 and 2007 were comprised of increases in ATM and overdraft charges, as well as additional fee revenue generated by the Campbell branch acquired during February 2007.
Increases in noninterest income experienced during 2007 were primarily the result of a $2.5 million gain recognized on the change in fair value to the Company’s junior subordinated debt. With the deterioration in credit markets during the second half of 2007, the rate on the Company’s junior subordinated debt was far below current market rates of interest on similar instruments, resulting in the significant gains recorded during the third and fourth quarters of 2007. This was offset during 2007 by a decline in gain on sale of investments, and gain on sale of fixed assets. Declines in gain on sale of investments resulted from a $1.8 million gain on the sale of an investment in correspondent bank during the first quarter of 2006, which was not again experienced during 2007. Declines in gain on sale of fixed assets resulted from a $1.0 million gain on the sale of the Company’s administrative headquarters during the third quarter of 2006, which was not again experienced during 2007. Noninterest income was further enhanced during the years ended December 31, 2007 and December 31, 2006 from death-benefit proceeds realized from the Company’s bank owned life insurance totaling $483,000 and $482,000 during those two years, respectively.
Shared appreciation income has fluctuated over the three years presented, with increases of $223,000 between 2007 and 2008, as compared to decreases of $525,000 between 2006 and 2007. Shared appreciation income results from agreements between the Company and the borrower on certain construction loans where the Company agrees to receive interest on the loan at maturity rather than monthly and the borrower agrees to share in the profits of the project. The profit is determined by the appraised value of the completed project and subsequent refinancing or sale of the project. Due to the difficulty in calculating future values, shared appreciation income is recognized when received. The Company does not participate in a significant number of shared appreciation projects, and as a result, does not anticipate large amounts of shared appreciation income on an ongoing basis.
Noninterest Expense
The following table sets forth the components of total noninterest expense in dollars and as a percentage of average earning assets for the years ended December 31, 2008, 2007 and 2006:
| | | 2008 | | | 2007 | | | 2006 | |
| | | | | | % of | | | | | | % of | | | | | | % of | |
| | | | | | Average | | | | | | Average | | | | | | Average | |
| | | | | | Earning | | | | | | Earning | | | | | | Earning | |
| (Dollars in thousands) | | Amount | | | Assets | | | Amount | | | Assets | | | Amount | | | Assets | |
| Salaries and employee benefits | | $ | 10,610 | | | | 1.52 | % | | $ | 10,830 | | | | 1.58 | % | | $ | 9,915 | | | | 1.69 | % |
| Occupancy expense | | | 3,954 | | | | 0.57 | % | | | 3,787 | | | | 0.55 | % | | | 2,556 | | | | 0.44 | % |
| Data processing | | | 279 | | | | 0.04 | % | | | 420 | | | | 0.06 | % | | | 470 | | | | 0.08 | % |
| Professional fees | | | 1,482 | | | | 0.21 | % | | | 1,811 | | | | 0.27 | % | | | 998 | | | | 0.17 | % |
| Directors fees | | | 262 | | | | 0.04 | % | | | 268 | | | | 0.04 | % | | | 222 | | | | 0.04 | % |
| Amortization of intangibles | | | 972 | | | | 0.14 | % | | | 1,021 | | | | 0.15 | % | | | 537 | | | | 0.09 | % |
| Correspondent bank service charges | | | 427 | | | | 0.06 | % | | | 476 | | | | 0.07 | % | | | 204 | | | | 0.03 | % |
| Impairment loss on other investments | | | 23 | | | | 0.00 | % | | | 17 | | | | 0.00 | % | | | 0 | | | | 0.00 | % |
| Impairment loss on OREO | | | 887 | | | | 0.13 | % | | | 0 | | | | 0.00 | % | | | 0 | | | | 0.00 | % |
| Impairment loss on intangible assets | | | 648 | | | | 0.09 | % | | | 0 | | | | 0.00 | % | | | 0 | | | | 0.00 | % |
| Loss on lease assets held for sale | | | 0 | | | | 0.00 | % | | | 820 | | | | 0.12 | % | | | 0 | | | | 0.00 | % |
| Loss on CA Tax Credit Partnership | | | 432 | | | | 0.06 | % | | | 430 | | | | 0.06 | % | | | 440 | | | | 0.08 | % |
| OREO expense | | | 418 | | | | 0.06 | % | | | 209 | | | | 0.03 | % | | | 2,193 | | | | 0.37 | % |
| Other | | | 2,885 | | | | 0.41 | % | | | 2,643 | | | | 0.39 | % | | | 2,402 | | | | 0.41 | % |
| Total | | $ | 23,279 | | | | 3.34 | % | | $ | 22,732 | | | | 3.33 | % | | $ | 19,937 | | | | 3.41 | % |
Noninterest expense, excluding provision for credit losses and income tax expense, totaled $23.3 million for the year ended December 31, 2008 as compared to $22.7 million and $19.9 million for the years ended December 31, 2007 and 2006, respectively. These figures represent an increase of $547,000 or 2.4% between the years ended December 31, 2007 and 2008 and an increase of $2.8 million or 14.0% between the years ended December 31, 2006 and 2007. As a percentage of average earning assets, total noninterest expense has remained relatively stable over the past three years as the Company has successfully controlled overhead expenses while experiencing profitable growth. Noninterest expense amounted to 3.34% of average earning assets for the year ended December 31, 2008 as compared to 3.33% at December 31, 2007 and 3.41% at December 31, 2006
Increases in noninterest expense between the years ended December 31, 2007 and December 31, 2008 include impairment losses of $887,000 on OREO, and $648,000 on intangible assets. With economic conditions deteriorating during 2008, increased emphasis has been placed on impairment review, as the values on many assets have declined. Impairment losses on OREO properties are also a function of an increase in the volume of OREO acquired during 2008, which is also reflected in the increase of $209,000 in OREO expense during 2008. Decreases in noninterest expense have been realized in many categories during 2008 including a decrease of $220,000 in salary expense, $141,000 in data processing expense, and $329,000 in professional fees. The decrease in salary expense between the years ended December 31, 2007 and December 31, 2008 is primarily the result of a reduction in bonuses and incentives paid during 2008, many of which are based upon the Company’s net income.
Increases in noninterest expense during 2007 included costs associated with the new branch operations in Campbell, California, resulting from the merger with Legacy Bank, additional employee costs associated with the new financial services department acquired during November 2007, increased professional fees associated with the resolution of impaired loans, losses on lease assets held for sale, and increased amortization costs for intangible assets. Losses on lease assets held for sale totaled $820,000 for the year ended December 31, 2007 and are the result of charge-offs of foreclosed lease assets, mainly equipment and furniture, which the Company has determined have no value or cannot be located. Decreases in OREO expense during 2007 were the primarily result of additional disposal and clean-up costs, incurred during 2006 on a single OREO property, which was in the process of liquidation. These additional OREO costs were not incurred again during 2007.
During the years ended December 31, 2008, 2007, and 2006, the Company recognized stock-based compensation expense of $110,000 ($0.01 per share basic and diluted), $187,000 ($0.02 per share basic and diluted), and $248,000 ($0.02 per share basic and diluted), respectively. This expense is included in noninterest expense under salaries and employee benefits. Under the current pool of stock options, the Company expects stock-based compensation expense to be about $13,000 per quarter during 2009, then to $6,000 per quarter for 2010, and decline after that through 2011. If new stock options are issued, or existing options fail to vest due, for example, to forfeiture, actual stock-based compensation expense in future periods will change.
On December 31, 2003 the California Franchise Tax Board (FTB) announced certain tax transactions related to real estate investment trusts (REITs) and regulated investment companies (RICs) will be disallowed pursuant to Senate Bill 614 and Assembly Bill 1601, which were signed into law in the 4th quarter of 2003. As a result, the Company reversed related net state tax benefits recorded in the first three quarters of 2003 and has taken no related tax benefits since that time. The Company continues to review the information available from the FTB and its financial advisors and believes that the Company's position has merit. The Company will pursue its tax claims and defend its use of these entities and transactions. At this time, the Company cannot predict the ultimate outcome.
During the first quarter of 2005, the FTB notified the Company of its intent to audit the REIT for the tax years ended December 2001 and 2002. The Company has retained legal counsel to represent it in the tax audit, and counsel has provided the FTB with documentation supporting the Company's position. The FTB concluded its audit during January 2006. During April 2006, the FTB issued a Notice of Proposed Assessment to the Company, which included proposed tax and penalty assessments related to the tax benefits taken for the REIT during 2002. The Company still believes the case has merit based upon the fact that the FTB is ignoring certain facts of law in the case. The issuance of the Notice of Proposed Assessment by the FTB will not end the administrative processing of the REIT issue because the Company has asserted its administrative protest and appeal rights pending the outcome of litigation by another taxpayer presently in process on the REIT issue in the Los Angeles Superior Court (City National v. Franchise Tax Board). The case is ongoing and may take several years to complete.
On January 1, 2007 the Company adopted Financial Accounting Standards Board (FASB) Interpretation 48 (FIN 48), “Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109”. FIN 48 clarifies SFAS No. 109, “Accounting for Income Taxes”, to indicate a criterion that an individual tax position would have to meet for some or all of the income tax benefit to be recognized in a taxable entity’s financial statements. Under the guidelines of FIN48, an entity should recognize the financial statement benefit of a tax position if it determines that it is more likely than not that the position will be sustained on examination. The term “more likely than not” means a likelihood of more than 50 percent.” In assessing whether the more-likely-than-not criterion is met, the entity should assume that the tax position will be reviewed by the applicable taxing authority.
The Company has reviewed its REIT tax position as of January 1, 2007 (adoption date), and then again each subsequent quarter thereafter in light of the adoption of FIN48. The Bank, with guidance from advisors believes that the case has merit with regard to points of law, and that the tax law at the time allowed for the deduction of the consent dividend. However, the Bank, with the concurrence of advisors, cannot conclude that it is “more than likely” (as defined in FIN48) that the Bank will prevail in its case with the FTB. As a result of this determination, effective January 1, 2007 the Company recorded an adjustment of $1.3 million to beginning retained earnings upon adoption of FIN48 to recognize the potential tax liability under the guidelines of the interpretation. The adjustment includes amounts for assessed taxes, penalties, and interest. During the years ended December 31, 2008 and 2007, the Company increased the unrecognized tax liability by an additional $87,000 in interest for each of the two years, bringing the total recorded tax liability under FIN48 to $1.5 million and $1.4 million at December 31, 2008, and December 31, 2007, respectively. It is the Company’s policy to recognize interest and penalties under FIN48 as a component of income tax expense. The Company has reviewed all of its tax positions as of December 31, 2008, and has determined that, other than the REIT, there are no other material amounts that should be recorded under the guidelines of FIN48.
Financial Condition
Total assets decreased by $10.6 million or 1.4% during the year to $761.1 million at December 31, 2008, but increased $82.8 million or 12.2% from the balance of $678.3 million at December 31, 2006. During the year ended December 31, 2008, decreases were experienced in loans as construction and real estate lending slowed and approximately $23.0 million in. problem loans were transferred to OREO. Interest-bearing deposits in other banks and investment securities increased by $17.5 million and $3.3 million, respectively, during the year ended December 31, 2008. During 2007, net loans increased $94.4 million, while federal funds sold decreased $14.3 million, and investment securities increased $6.0 million between the two period-ends. The Legacy Bank acquisition completed during February 2007 added $62.4 million in net loans, $7.4 in investments, and $69.6 in deposits to the Company’s balance sheet during 2007.
Total deposits of $508.5 million at December 31, 2008 decreased $126.1 million or 19.9% from the balance reported at December 31, 2007, and decreased $78.6 million or 13.4% from the balance of $587.1 million reported at December 31, 2006. During 2008, growth of $10.5 million and $13.4 million was experienced in noninterest-bearing deposits and time deposits of less than $100,000, respectively, which was more than offset by substantial declines in time deposits of $100,000 or more, and to a lesser degree interest-bearing checking and savings accounts. The decrease of $130.9 million in time deposits of $100,000 or more experienced during 2008 was primarily the result of brokered time deposits and deposits from the State of California, which were not renewed as they matured during 2008. The brokered time deposits were replaced with less expensive borrowings including FHLB advances and overnight borrowings from the Federal Reserve Discount Window.
Earning assets averaged approximately $697.9 million during the year ended December 31, 2008, as compared to $683.4 million and $585.5 million for the years ended December 31, 2007 and 2006, respectively. Average interest-bearing liabilities increased to $542.7 million for the year ended December 31, 2008, as compared to $526.0 million for the year ended December 31, 2007, and increased from the balance of $438.1 million for the year ended December 31, 2006.
Loans
The Company's primary business is that of acquiring deposits and making loans, with the loan portfolio representing the largest and most important component of its earning assets. Loans totaled $550.0 million at December 31, 2008, representing a decrease of $48.2 million or 8.1% when compared to the balance of $598.2 million at December 31, 2007, and an increase of $49.4 million or 9.9% when compared to the balance of $500.6 million reported at December 31, 2006. Total loans decreased approximately $57.1 million during the fourth quarter of 2008, about half of which was the result of transfers of nonperforming loans to OREO. Average loans totaled $587.9 million, $580.9 million, and $470.0 million for the years ended December 31, 2008, 2007 and 2006, respectively. During 2008 average loans increased 1.2% when compared to the year ended December 31, 2007 and increased 25.1% compared to the year ended December 31, 2006.
The following table sets forth the amounts of loans outstanding by category and the category percentages as of the year-end dates indicated:
| | | 2008 | | | 2007 | | | 2006 | | | 2005 | | | 2004 | |
| | | Dollar | | | % of | | | Dollar | | | % of | | | Dollar | | | % of | | | Dollar | | | % of | | | Dollar | | | % of | |
(In thousands) | | Amount | | | Loans | | | Amount | | | Loans | | | Amount | | | Loans | | | Amount | | | Loans | | | Amount | | | Loans | |
| Commercial and industrial | | $ | 223,581 | | | | 40.7 | % | | $ | 204,385 | | | | 34.2 | % | | $ | 155,811 | | | | 31.1 | % | | $ | 113,263 | | | | 27.1 | % | | $ | 123,720 | | | | 31.0 | % |
| Real estate – mortgage | | | 126,689 | | | | 23.0 | | | | 142,565 | | | | 23.8 | | | | 113,613 | | | | 22.7 | | | | 89,503 | | | | 21.4 | | | | 88,187 | | | | 22.1 | |
| Real estate – construction | | | 119,885 | | | | 21.7 | | | | 178,296 | | | | 29.8 | | | | 168,378 | | | | 33.7 | | | | 162,873 | | | | 38.9 | | | | 137,523 | | | | 34.5 | |
| Agricultural | | | 52,020 | | | | 9.5 | | | | 46,055 | | | | 7.7 | | | | 35,102 | | | | 7.0 | | | | 24,935 | | | | 6.0 | | | | 23,416 | | | | 5.9 | |
| Installment/other | | | 20,782 | | | | 3.8 | | | | 18,171 | | | | 3.0 | | | | 16,712 | | | | 3.3 | | | | 15,002 | | | | 3.6 | | | | 13,257 | | | | 3.3 | |
| Lease financing | | | 7,020 | | | | 1.3 | | | | 8,748 | | | | 1.5 | | | | 10,952 | | | | 2.2 | | | | 12,334 | | | | 3.0 | | | | 12,581 | | | | 3.2 | |
| Total Loans | | $ | 549,977 | | | | 100.0 | % | | $ | 598,220 | | | | 100.0 | % | | $ | 500,568 | | | | 100.0 | % | | $ | 417,910 | | | | 100.0 | % | | $ | 398,684 | | | | 100.0 | % |
Loan volume continues to be greatest in what has historically been the Bank’s primary lending emphasis: commercial, real estate mortgage, and construction lending. With the continued deterioration of real estate markets during 2008, the Company experienced a decrease of $58.4 million or 32.8 % in construction loans, and a decrease of $15.9 million in real estate mortgage loans. Lease financing decreased $1.7 million during 2008, as the Company is no longer originating commercial leases. Partially offsetting these decreases were increases of $19.2 million in commercial loans, $6.0 million in agricultural loans, and $2.6 million in consumer installment loans. Part of the decrease in construction and real estate loans experienced during 2008 is the result of transfers of approximately $28.5 million ($26.0 million net of charge-offs) in nonperforming loans to OREO.
During 2007 loan growth occurred in all categories except lease financing. During 2007, significant increases occurred in commercial and industrial loans, as well as real estate mortgage loans, with increases of $48.6 million or 31.2% and $29.0 million or 25.5% in those two categories, respectively. Agricultural loans increased $11.0 million or 31.2% during 2007, and real estate construction loans increased $9.9 million or 5.9% during 2007. The acquisition of Legacy Bank during February 2007 contributed approximately $63.9 million to the loan growth experienced during 2007. During the fourth quarter of 2007 loan volume declined approximately $27.7 million or 4.4% as the Company slowed additional loan growth as part of its asset/liability management and liquidity plan.
During 2006, loan growth occurred in all categories except lease financing. The most significant loan increases during 2006 occurred in commercial and industrial loans, real estate mortgage loans, and agricultural loans, with increases of $42.5 million, $24.1 million, and $10.2 million experienced in those three categories, respectively. Real estate construction loans increased a modest $5.5 million or 3.4% during 2006 as the real estate construction market remained stable within the San Joaquin Valley.
At December 31, 2008, approximately 78% of commercial and industrial loans have floating rates and, although some may be secured by real estate, many are secured by accounts receivable, inventory, and other business assets. Residential housing markets have suffered considerably since the later half of 2007, and as a result, residential construction loans decreased during 2008. Real estate construction loans decreased $58.4 million or 32.8% during 2008, as compared to an increase of $9.9 million or 5.9 % during 2007, and an increase of $5.5 million or 3.4% during 2006. Construction loans are generally short-term, floating-rate obligations, which consist of both residential and commercial projects. Agricultural loans consisting of mostly short-term, floating rate loans for crop financing, increased $6.0 million or 13.0% between December 31, 2007 and December 31, 2008, while installment loans increased $2.6 million or 14.4% during that same period.
The real estate mortgage loan portfolio totaling $126.7 million at December 31, 2008 consists of commercial real estate, residential mortgages, and home equity loans. Commercial real estate is the core of this segment of the portfolio, with balances of $81.8 million, $102.4 million, and $71.7 million at December 31, 2008, 2007, and 2006, respectively. Commercial real estate loans are generally a mix of short to medium-term, fixed and floating rate instruments and, are mainly tied to commercial income and multi-family residential properties. The Company does not currently offer traditional residential mortgage loans, but may purchase mortgage portfolios. As a result of real estate mortgage purchases over the past several years, that portion of the portfolio has remained stable with balances of $41.6 million, $37.2 million, and $39.2 million at December 31, 2008, 2007 and 2006, respectively. The Company also offers short to medium-term, fixed-rate, home equity loans, which totaled $3.2 million at December 31, 2008, $3.0 million at December 31, 2007, and $2.7 million at December 31, 2006.
The following table sets forth the maturities of the Bank's loan portfolio at December 31, 2008. Amounts presented are shown by maturity dates rather than repricing periods:
| | | | | | Due after one | | | | | | | |
| | | Due in one | | | Year through | | | Due after | | | | |
| (In thousands) | | year or less | | | Five years | | | Five years | | | Total | |
| Commercial and agricultural | | $ | 174,972 | | | $ | 78,307 | | | $ | 22,321 | | | $ | 275,600 | |
| Real estate – construction | | | 116,856 | | | | 3,028 | | | | 0 | | | | 119,884 | |
| | | | 291,828 | | | | 81,335 | | | | 22,321 | | | | 395,484 | |
| Real estate – mortgage | | | 13,968 | | | | 59,703 | | | | 53,018 | | | | 126,689 | |
| All other loans | | | 13,383 | | | | 11,649 | | | | 2,771 | | | | 27,803 | |
| Total Loans | | $ | 319,179 | | | $ | 152,687 | | | $ | 78,110 | | | $ | 549,976 | |
The average yield on loans was 6.75% for the year ended December 31, 2008, representing a decrease of 232 basis points when compared to the year ended December 31, 2007 and was a result of a significant decrease in market rates of interest during 2008. The average loan yield for 2008 was also impacted by the reversal of approximately $1.0 million in interest on nonaccrual loans, reducing the average loan yield by 17 basis points for the year ended December 31, 2008. For the year ended December 31, 2007, the average yield on loans was 9.07%, representing a decrease of 6 basis points when compared to the year ended December 31, 2006 and was a result of increased loan pricing pressures experienced during 2007 which more than outweighed an average increase of 9 basis point in the prime rate between the year ended December 31, 2006 and December 31, 2007. The Bank’s loan portfolio is generally comprised of short-term or floating rate loans and is therefore susceptible to fluctuations in market rates of interest. At December 31, 2008, 2007 and 2006, approximately 64.0%, 62.3% and 59.5% of the Bank's loan portfolio consisted of floating rate instruments, with the majority of those tied to the prime rate.
The following table sets forth the contractual maturities of the Bank's fixed and floating rate loans at December 31, 2008. Amounts presented are shown by maturity dates rather than repricing periods, and do not consider renewals or prepayments of loans:
| | | | | | Due after one | | | | | | | |
| | | Due in one | | | Year through | | | Due after | | | | |
| (In thousands) | | year or less | | | Five years | | | Five years | | | Total | |
| Accruing loans: | | | | | | | | | | | | |
| Fixed rate loans | | $ | 42,582 | | | $ | 75,327 | | | $ | 65,020 | | | $ | 182,929 | |
| Floating rate loans | | | 231,533 | | | | 72,300 | | | | 12,118 | | | | 315,951 | |
| Total accruing loans | | | 274,115 | | | | 147,627 | | | | 77,138 | | | | 498,880 | |
| Nonaccrual loans: | | | | | | | | | | | | | | | | |
| Fixed rate loans | | | 7,783 | | | | 5,060 | | | | 591 | | | | 13,434 | |
| Floating rate loans | | | 37,281 | | | | 0 | | | | 381 | | | | 37,662 | |
| Total nonaccrual loans | | | 45,064 | | | | 5,060 | | | | 972 | | | | 51,096 | |
| Total Loans | | $ | 319,179 | | | $ | 152,687 | | | $ | 78,110 | | | $ | 549,976 | |
Securities
Following is a comparison of the amortized cost and approximate fair value of available-for-sale for the three years indicated:
| | | December 31, 2008 | | | December 31, 2007 | |
| | | | | | Gross | | | Gross | | | Fair Value | | | | | | Gross | | | Gross | | | Fair Value | |
| | | Amortized | | | Unrealized | | | Unrealized | | | (Carrying | | | Amortized | | | Unrealized | | | Unrealized | | | (Carrying | |
(In thousands) | | Cost | | | Gains | | | Losses | | | Amount) | | | Cost | | | Gains | | | Losses | | | Amount) | |
Available-for-sale: | | | | | | | | | | | | | | | | | | | | | | | | |
| U.S. Government agencies | | $ | 43,110 | | | $ | 1,280 | | | $ | (204 | ) | | $ | 44,186 | | | $ | 65,764 | | | $ | 524 | | | $ | (302 | ) | | $ | 65,986 | |
| Collateralized mortgage | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| obligations | | | 39,068 | | | | 189 | | | | (4,991 | ) | | | 34,266 | | | | 7,782 | | | | 44 | | | | (4 | ) | | | 7,822 | |
| Obligations of state and | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| political subdivisions | | | 1,252 | | | | 28 | | | | 0 | | | | 1,280 | | | | 2,227 | | | | 54 | | | | 0 | | | | 2,281 | |
| Other investment securities | | | 13,880 | | | | 0 | | | | (863 | ) | | | 13,017 | | | | 13,752 | | | | 0 | | | | (426 | ) | | | 13,326 | |
| Total available-for-sale | | $ | 97,310 | | | $ | 1,497 | | | $ | (6,058 | ) | | $ | 92,749 | | | $ | 89,525 | | | $ | 622 | | | $ | (732 | ) | | $ | 89,415 | |
| | | December 31, 2006 | |
| | | | | | Gross | | | Gross | | | | |
| | | Amortized | | | Unrealized | | | Unrealized | | | Fair | |
| (In thousands) | | Cost | | | Gains | | | Losses | | | Value | |
| Available-for-sale: | | | | | | | | | | | | |
| U.S. Government agencies | | $ | 69,746 | | | $ | 51 | | | $ | (1,293 | ) | | $ | 68,504 | |
| Collateralized mortgage obligations | | | 17 | | | | 0 | | | | (1 | ) | | | 16 | |
| Obligations of state and | | | | | | | | | | | | | | | | |
| political subdivisions | | | 2,226 | | | | 65 | | | | (1 | ) | | | 2,290 | |
| Other investment securities | | | 13,000 | | | | 0 | | | | (444 | ) | | | 12,556 | |
| Total available-for-sale | | $ | 84,989 | | | $ | 116 | | | $ | (1,739 | ) | | $ | 83,366 | |
Included in other investment securities at December 31, 2008, is a short-term government securities mutual fund totaling $7.2 million, a CRA-qualified mortgage fund totaling $4.9 million, and an overnight money-market mutual fund totaling $880,000. Included in other investment securities at December 31, 2007, is a short-term government securities mutual fund totaling $7.7 million, a CRA-qualified mortgage fund totaling $4.9 million, and an overnight money-market mutual fund totaling $752,000. Included in other investment securities at December 31, 2006, is a short-term government securities mutual fund totaling $7.7 million, and a CRA-qualified mortgage fund totaling $4.8 million. The commercial asset-backed trust consists of fixed and floating rate commercial and multifamily mortgage loans. The short-term government securities mutual fund invests in debt securities issued or guaranteed by the U.S. Government, its agencies or instrumentalities, with a maximum duration equal to that of a 3-year U.S. Treasury Note.
There were realized gains on available-for-sale securities totaling $24,000 and $27,000 for the years ended December 31, 2008 and 2006, respectively. There were no realized gains or losses on securities available-for-sale during 2007. There were no realized losses on securities available-for-sale during 2008 or 2006.
Investment securities increased $3.3 million between December 2007 and December 2008, as U.S. government agencies and municipal bonds were either paid down or matured, and additional funds from maturing loans were utilized to purchase additional investment securities or interest-bearing deposits in other banks. Investment securities increased $6.0 million between December 2006 and December 2007 primarily as the result of the Legacy merger during February 2007 in which approximately $6.8 million in U.S Agency securities and $625,000 in other investment securities were added to the Company’s portfolio.
Securities that have been temporarily impaired less than 12 months at December 31, 2008 are comprised of four collateralized mortgage obligations with a weighted average life of 3.66 years, and seven U.S. agency bonds with a weighted average life of 3.18 years. As of December 31, 2008, there were two other investment securities with a total weighted average life of 0.50 years that have been temporarily impaired for twelve months or more. The unrealized losses are due in most part to interest rate changes, as well as credit downgrades in some of the portfolio including three collateralized mortgage obligations. The Company has the ability and intent to hold all investment securities with identified impairments resulting from interest rate changes and credit downgrades to the earlier of the forecasted recovery or the maturity of the underlying investment security. The Company believes that credit downgrades on securities within the portfolio are a result of the severity of the current economic downturn and does not believe the downgrades will result in other-than-temporary impairment of those securities. As a result, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2008
The following summarizes temporarily impaired investment securities at December 31, 2008
| | | Less than 12 Months | | | 12 Months or More | | | Total | |
| (In thousands) | | Fair Value | | | | | | Fair Value | | | | | | Fair Value | | | | |
| | | (Carrying | | | Unrealized | | | (Carrying | | | Unrealized | | | (Carrying | | | Unrealized | |
| Securities available for sale: | | Amount) | | | Losses | | | Amount) | | | Losses | | | Amount) | | | Losses | |
| U.S. Government agencies | | $ | 6,471 | | | $ | (204 | ) | | $ | 0 | | | $ | 0 | | | $ | 6,471 | | | $ | (204 | ) |
| Collateralized mortgage | | | | | | | | | | | | | | | | | | | | | | | | |
| obligations | | | 17,568 | | | | (4,991 | ) | | | 0 | | | | 0 | | | | 17,568 | | | | (4,991 | ) |
| Obligations of state and | | | | | | | | | | | | | | | | | | | | | | | | |
| political subdivisions | | | 0 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | |
| Other investment securities | | | 0 | | | | 0 | | | | 12,137 | | | | (863 | ) | | | 12,137 | | | | (863 | ) |
| Total impaired securities | | $ | 24,039 | | | $ | (5,195 | ) | | $ | 12,137 | | | $ | (863 | ) | | $ | 36,176 | | | $ | (6,058 | ) |
Securities that have been temporarily impaired less than 12 months at December 31, 2007 are comprised of one U.S. government agency collateralized mortgage obligation with a weighted average life of 1.19 years. As of December 31, 2007, there were nine U.S. government agency securities, and two other investment securities with a total weighted average life of 0.97 years that have been temporarily impaired for twelve months or more. Because the decline in market value is attributable to changes in market rates of interest rather than credit quality, and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2007.
The following summarizes temporarily impaired investment securities at December 31, 2007
| | | Less than 12 Months | | | 12 Months or More | | | Total | |
| (In thousands) | | Fair Value | | | | | | Fair Value | | | | | | Fair Value | | | | |
| | | (Carrying | | | Unrealized | | | (Carrying | | | Unrealized | | | (Carrying | | | Unrealized | |
| Securities available for sale: | | Amount) | | | Losses | | | Amount) | | | Losses | | | Amount) | | | Losses | |
| U.S. Government agencies | | $ | 0 | | | $ | 0 | | | $ | 30,241 | | | $ | (302 | ) | | $ | 30,241 | | | $ | (302 | ) |
| Collateralized mortgage | | | | | | | | | | | | | | | | | | | | | | | | |
| obligations | | | 4,129 | | | | (4 | ) | | | 0 | | | | 0 | | | | 4,129 | | | | (4 | ) |
| Obligations of state and | | | | | | | | | | | | | | | | | | | | | | | | |
| political subdivisions | | | 0 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | |
| Other investment securities | | | 0 | | | | 0 | | | | 12,574 | | | | (426 | ) | | | 12,574 | | | | (426 | ) |
| Total impaired securities | | $ | 4,129 | | | $ | (4 | ) | | $ | 42,815 | | | $ | (728 | ) | | $ | 46,944 | | | $ | (732 | ) |
Securities that have been temporarily impaired less than 12 months at December 31, 2006 are comprised of one U.S. government agency security with a weighted average life of 13.2 years. As of December 31, 2006, there were nineteen U.S. government agency securities, one collateralized mortgage obligation, one municipal security, and two other investment securities with a total weighted average life of 2.29 years that have been temporarily impaired for twelve months or more. Because the decline in market value is attributable to changes in market rates of interest rather than credit quality, and because the Company has the ability and intent to hold these investments until a recovery of fair value, which may be maturity, the Company does not consider these investments to be other-than-temporarily impaired at December 31, 2006.
The following summarizes temporarily impaired investment securities at December 31, 2006
| | | Less than 12 Months | | | 12 Months or More | | | Total | |
| (In thousands) | | Fair Value | | | | | | Fair Value | | | | | | Fair Value | | | | |
| | | (Carrying | | | Unrealized | | | (Carrying | | | Unrealized | | | (Carrying | | | Unrealized | |
| Securities available for sale: | | Amount) | | | Losses | | | Amount) | | | Losses | | | Amount) | | | Losses | |
| U.S. Government agencies | | $ | 506 | | | $ | (6 | ) | | $ | 65,626 | | | $ | (1,287 | ) | | $ | 66,132 | | | $ | (1,293 | ) |
| Collateralized mortgage | | | | | | | | | | | | | | | | | | | | | | | | |
| obligations | | | 0 | | | | 0 | | | | 12 | | | | (1 | ) | | | 12 | | | | (1 | ) |
| Obligations of state and | | | | | | | | | | | | | | | | | | | | | | | | |
| political subdivisions | | | 0 | | | | 0 | | | | 34 | | | | (1 | ) | | | 34 | | | | (1 | ) |
| Other investment securities | | | 0 | | | | 0 | | | | 12,556 | | | | (444 | ) | | | 12,556 | | | | (444 | ) |
| Total impaired securities | | $ | 506 | | | $ | (6 | ) | | $ | 78,228 | | | $ | (1,733 | ) | | $ | 78,734 | | | $ | (1,739 | ) |
The contractual maturities of investment securities as well as yields based on amortized cost of those securities at December 31, 2008 are shown below. Actual maturities may differ from contractual maturities because issuers have the right to call or prepay obligations with or without call or prepayment penalties.
| | | One year or less | | | After one year to five years | | | After five years to
ten years | | | After ten years | | | Total | |
(Dollars in thousands) | | Amount | | | Yield (1) | | | Amount | | | Yield (1) | | | Amount | | | Yield (1) | | | Amount | | | Yield (1) | | | Amount | | | Yield (1) | |
| Available-for-sale: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| U.S. Government agencies | | $ | 700 | | | | 3.78 | % | | $ | 3,642 | | | | 3.65 | % | | $ | 8,601 | | | | 5.29 | % | | $ | 31,243 | | | | 4.58 | % | | $ | 44,186 | | | | 4.70 | % |
| Collateralized mortgage | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| obligations | | | — | | | | — | | | | 3,104 | | | | 4.73 | % | | | 5,826 | | | | 4.57 | % | | | 25,336 | | | | 6.05 | % | | | 34,266 | | | | 5.78 | % |
| Obligations of state and | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| political subdivisions | | | — | | | | — | | | | 352 | | | | 4.37 | % | | | 928 | | | | 4.64 | % | | | — | | | | — | | | | 1,280 | | | | 4.57 | % |
| Other investment securities | | | 13,017 | | | | 5.11 | % | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 13,017 | | | | 5.11 | % |
| Total estimated fair value | | $ | 13,717 | | | | 5.05 | % | | $ | 7,098 | | | | 4.16 | % | | $ | 15,355 | | | | 4.98 | % | | $ | 56,579 | | | | 5.24 | % | | $ | 92,749 | | | | 5.40 | % |
| (1) Weighted average yields are not computed on a tax equivalent basis | | | | | | | | | |
At December 31, 2008 and 2007, available-for-sale securities with an amortized cost of approximately $81.4 million and $71.0 million, respectively (fair value of $79.6 million and $71.3 million, respectively) were pledged as collateral for public funds, FHLB borrowings, and treasury tax and loan balances.
Deposits
The Bank attracts commercial deposits primarily from local businesses and professionals, as well as retail checking accounts, savings accounts and time deposits. Total deposits decreased $126.1 million or 19.9% during the year to a balance of $508.5 million at December 31, 2008 and increased $47.5 million or 8.1% between December 31, 2006 and December 31, 2007. Core deposits, consisting of all deposits other than time deposits of $100,000 or more and brokered deposits, continue to provide the foundation for the Bank's principal sources of funding and liquidity. These core deposits amounted to 71.9%, 59.9% and 71.0% of the total deposit portfolio at December 31, 2008, 2007 and 2006, respectively.
The following table sets forth the year-end amounts of deposits by category for the years indicated, and the dollar change in each category during the year:
| | | December 31, | | | Change during Year | |
| (In thousands) | | 2008 | | | 2007 | | | 2006 | | | 2008 | | | 2007 | |
| Noninterest-bearing deposits | | $ | 149,529 | | | $ | 139,066 | | | $ | 159,002 | | | $ | 10,463 | | | $ | (19,936 | ) |
| Interest-bearing deposits: | | | | | | | | | | | | | | | | | | | | |
| NOW and money market accounts | | | 136,612 | | | | 153,717 | | | | 184,384 | | | | (17,105 | ) | | | (30,667 | ) |
| Savings accounts | | | 37,586 | | | | 40,012 | | | | 31,933 | | | | (2,426 | ) | | | 8,079 | |
| Time deposits: | | | | | | | | | | | | | | | | | | | | |
| Under $100,000 | | | 66,128 | | | | 52,297 | | | | 42,428 | | | | 13,831 | | | | 9,869 | |
| $100,000 and over | | | 118,631 | | | | 249,525 | | | | 169,380 | | | | (130,894 | ) | | | 80,145 | |
| Total interest-bearing deposits | | | 358,957 | | | | 495,551 | | | | 428,125 | | | | (136,594 | ) | | | 67,426 | |
| Total deposits | | $ | 508,486 | | | $ | 634,617 | | | $ | 587,127 | | | $ | (126,131 | ) | | $ | 47,490 | |
During the year ended December 31, 2008, decreases were experienced primarily in time deposits, and to a lesser degree in interest-bearing checking accounts and saving accounts. Brokered and other time deposits were allowed to runoff as they matured during 2008, as the Company sought other less-expensive funding sources including FHLB advances and overnight borrowings from the Federal Reserve. In addition, time deposits from the State of California, which totaled $45.0 million at both December 31, 2007 and December 31, 2006, were not renewed by the State of California during 2008. The Company had increased brokered deposits throughout 2007 as part of its liquidity strategy begun during 2006 to fund loan growth as core deposits became increasingly difficult to obtain and pricing became more competitive. As market rates of interest declined during 2008, brokered deposit pricing did not decline to the same degree, due largely to liquidity and credit issues in the market place. As a result, brokered deposits and other time deposits became less attractive as a funding source. Brokered deposits totaled $93.4 million, $139.3 million, and $67.7 million at December 31, 2008, 2007 and 2006, respectively. The Company will continue to use pricing strategies to control the overall level of time deposits and other borrowings as part of its growth and liquidity planning process. NOW and money market accounts, as well as savings accounts declined $17.1 million and $2.4 million, respectively, between December 31, 2007 and December 31, 2008 as these deposits remain competitive. The Company continues to emphasize core deposits as part of its relationship banking strategy. As a result, core deposits, including NOW and money market accounts, and savings accounts, as well as noninterest-bearing checking accounts, continue to provide the Company’s primary funding source.
During the year ended December 31, 2007 increases were experienced primarily in time deposits, and to a lesser degree in saving accounts. Increases in time deposits during 2007 were largely the result brokered time deposits obtained by the Company as part of its liquidity strategy begun during 2006 to fund loan growth as core deposits became increasingly difficult to obtain and pricing became more competitive. This liquidity strategy allowed the Company to obtain the additional funding sources needed during 2007 to fund loan growth without adversely impacting the cost of its core deposit base. NOW and money market accounts, as well as noninterest-bearing deposits declined $30.7 million and $19.9 million, respectively, between December 31, 2006 and December 31, 2007 as these deposits became increasingly competitive.
During the year ended December 31, 2006 increases were experienced in all deposit categories, except in time deposits under $100,000 and savings deposits. Increases experienced during 2006 in money market accounts and time deposits in excess of $100,000 are primarily the result of depositors seeking higher yields during the year as competitors such as brokerage firms and credit unions have drove up rates to attract deposits. Increases in time deposits of $100,000 and over experienced during 2006 were largely the result of brokered time deposits obtained by the Company as part of its liquidity strategy to fund loan growth during the year.
The Company's deposit base consists of two major components represented by noninterest-bearing (demand) deposits and interest-bearing deposits. Interest-bearing deposits consist of time certificates, NOW and money market accounts and savings deposits. Total noninterest-bearing deposits increased $10.5 million or 7.5% between December 31, 2007 and December 31, 2008, while interest-bearing deposits decreased $136.6 million or 27.6% between the same two periods presented. Between December 31, 2006 and December 31, 2007, total interest-bearing deposits increased $67.4 million or 15.6%, while noninterest-bearing deposits decreased $19.9 million or 12.5%. Deposit balances acquired in the acquisition of Legacy Bank duiring February 2007 totaled approximately $69.6 million. Exclusive of the deposits acquired from Legacy Bank during the first quarter of 2007, deposit balances attributable to the Company’s previously existing deposit base decreased approximately $22.1 million during the year ended December 31, 2007.
On a year-to-date average basis, total deposits decreased $56.1 million or 8.8% between the years ended December 31, 2007 and December 31, 2008. Of that total, interest-bearing deposits decreased by $53.9 million or 10.9%, while noninterest-bearing deposits decreased $2.2 million or 1.5% during 2008. On average, the Company experienced decreases in all deposit categories between the years ended December 31, 2007 and December 31, 2008.
On a year-to-date average, the Company experienced an increase of $74.3 million or 3.2 % in total deposits between the years ended December 31, 2006 and December 31, 2007. Between these two periods, average interest-bearing deposits increased $74.1 million or 17.7%, while total noninterest-bearing checking increased $232,000 or 0.16% on a year-to-date average basis. On average, the Company experienced increases in savings accounts and time deposits between the years ended December 31, 2006 and December 31, 2007, while other deposit categories experienced moderate declines on average during 2007.
The following table sets forth the average deposits and average rates paid on those deposits for the years ended December 31, 2008, 2007 and 2006:
| | | 2008 | | | 2007 | | | 2006 | |
| | | Average | | | | | | Average | | | | | | Average | | | | |
(Dollars in thousands) | | Balance | | | Rate % | | | Balance | | | Rate % | | | Balance | | | Rate % | |
| Interest-bearing deposits: | | | | | | | | | | | | | | | | | | |
| Checking accounts | | $ | 167,190 | | | | 1.91 | % | | $ | 183,102 | | | | 2.48 | % | | $ | 187,360 | | | | 2.10 | % |
| Savings | | | 40,699 | | | | 1.18 | % | | | 46,225 | | | | 1.91 | % | | | 35,135 | | | | 0.56 | % |
| Time deposits (1) | | | 230,746 | | | | 3.65 | % | | | 263,196 | | | | 4.94 | % | | | 195,922 | | | | 4.32 | % |
| Noninterest-bearing deposits | | | 144,772 | | | | | | | | 146,954 | | | | | | | | 146,722 | | | | | |
| (1) | Included at December 31, 2008, are $118.6 million in time certificates of deposit of $100,000 or more, of which $48.0 million matures in three months or less, $48.3 million matures in 3 to 6 months, $14.2 million matures in 6 to 12 months, and $8.1 million matures in more than 12 months. |
Short-term Borrowings
The Company has the ability to obtain borrowed funds consisting of federal funds purchased, securities sold under agreements to repurchase (“repurchase agreements”) and Federal Home Loan Bank (“FHLB”) advances as alternatives to retail deposit funds. The Company has established collateralized and uncollateralized lines of credit with several correspondent banks, as well as a securities dealer, for the purpose of obtaining borrowed funds as needed. The Company may continue to borrow funds in the future as part of its asset/liability strategy, and may use these funds to acquire certain other assets as deemed appropriate by management for investment purposes and to better utilize the capital resources of the Bank. Federal funds purchased represent temporary overnight borrowings from correspondent banks and are generally unsecured. Repurchase agreements are collateralized by mortgage backed securities and securities of U.S. Government agencies, and generally have maturities of one to six months, but may have longer maturities if deemed appropriate as part of the Company’s asset/liability management strategy. FHLB advances are collateralized by the Company’s investment in FHLB stock, securities, and certain qualifying mortgage loans. In addition, the Company has the ability to obtain borrowings from the Federal Reserve Bank of San Francisco, which would be collateralized by certain pledged loans in the Company’s loan portfolio. The lines of credit are subject to periodic review of the Company’s financial statements by the grantors of the credit lines. Lines of credit may be modified or revoked at any time if the grantors feel there are adverse trends in the Company’s financial position.
The Company had collateralized and uncollateralized lines of credit aggregating $242.7 million and $386.7 million, as well as FHLB lines of credit totaling $97.1 million and $22.0 million at December 31, 2008 and 2007, respectively. At December 31, 2008, the Company had total outstanding balances of $88.5 million drawn against its FHLB line of credit. Of the $88.5 million in FHLB borrowings outstanding at December 31, 2008, $77.5 million was in borrowings with maturities of one year or less with an average rate of 1.05%, and the other $11.0 million consists of a two-year FHLB advance, with an average fixed rate of 2.67%. These lines of credit generally have interest rates tied to the Federal Funds rate or are indexed to short-term U.S. Treasury rates or LIBOR.
The table below provides further detail of the Company’s federal funds purchased, repurchase agreements and FHLB advances for the years ended December 31, 2008, 2007 and 2006:
| | | December 31, | |
| (Dollars in thousands) | | 2008 | | | 2007 | | | 2006 | |
| At period end: | | | | | | | | | |
| Federal funds purchased | | $ | 66,545 | | | $ | 10,380 | | | $ | 0 | |
| Repurchase agreements | | | 0 | | | | 0 | | | | 0 | |
| FHLB advances | | | 88,500 | | | | 21,900 | | | | 0 | |
| Total at period end | | $ | 155,045 | | | $ | 32,280 | | | $ | 0 | |
| Average ending interest rate – total | | | 0.93 | % | | | 4.10 | % | | | 0.00 | % |
| Average for the year: | | | | | | | | | | | | |
| Federal funds purchased | | $ | 58,432 | | | $ | 4,660 | | | $ | 4,209 | |
| Repurchase agreements | | | 0 | | | | 0 | | | | 0 | |
| FHLB advances | | | 32,937 | | | | 13,231 | | | | 0 | |
| Total average for the year | | $ | 91,369 | | | $ | 17,891 | | | $ | 4,209 | |
| Average interest rate – total | | | 2.32 | % | | | 5.17 | % | | | 5.30 | % |
| Maximum total borrowings outstanding at | | | | | | | | | | | | |
| any month-end during the year: | | | | | | | | | | | | |
| Federal funds purchased | | $ | 160,083 | | | $ | 16,400 | | | $ | 17,100 | |
| Repurchase agreements/FHLB advances | | | 28,000 | | | | 20,000 | | | | 0 | |
| Total | | $ | 188,083 | | | $ | 36,400 | | | $ | 17,100 | |
Asset Quality and Allowance for Credit Losses
Lending money is the Company's principal business activity, and ensuring appropriate evaluation, diversification, and control of credit risks is a primary management responsibility. Implicit in lending activities is the fact that losses will be experienced and that the amount of such losses will vary from time to time, depending on the risk characteristics of the loan portfolio as affected by local economic conditions and the financial experience of borrowers.
The allowance for credit losses is maintained at a level deemed appropriate by management to provide for known and inherent risks in existing loans and commitments to extend credit. The adequacy of the allowance for credit losses is based upon management's continuing assessment of various factors affecting the collectibility of loans and commitments to extend credit; including current economic conditions, past credit experience, collateral, and concentrations of credit. There is no precise method of predicting specific losses or amounts which may ultimately be charged off on particular segments of the loan portfolio. The collectibility of a loan is subjective to some degree, but must relate to the borrower’s financial condition, cash flow, quality of the borrower’s management expertise, collateral and guarantees, and the state of the local economy. When determining the adequacy of the allowance for credit losses, the Company follows, in accordance with GAAP, the guidelines set forth in the Interagency Policy Statement on the Allowance for Loan and Lease Losses (“Statement”) issued jointly by banking regulators during 2003, and updated and revised in 2006. The Statement outlines characteristics that should be used in segmentation of the loan portfolio for purposes of the analysis including risk classification, past due status, type of loan, industry or collateral. It also outlines factors to consider when adjusting the loss factors for various segments of the loan portfolio. Securities and Exchange Commission Staff Accounting Bulletin No. 102 was also released at this time which represents the SEC staff’s view relating to methodologies and supporting documentation for the Allowance for Loan and Lease Losses that should be observed by all public companies in complying with the federal securities laws and the Commission’s interpretations. It is also generally consistent with the guidance published by the banking regulators.
The Company segments the loan and lease portfolio into eleven (11) segments, primarily by loan class and type, that have homogeneity and commonality of purpose and terms for analysis under SFAS No. 5. Those loans which are determined to be impaired under SFAS No. 114 are not subject to the general reserve analysis under SFAS No. 5, and evaluated individually for specific impairment. The eleven segments of the Company’s loan portfolio are as follows (subtotals are provided as needed to allow the reader to reconcile the amounts to the Company’s loan classification reported elsewhere in these financial statements):
| Loan Segments for Loan Loss Reserve Analysis | | Loan Balance at December 31, | |
| (dollars in 000's) | | 2008 | | | 2007 | | | 2006 | | | 2005 | | | 2004 | |
| 1 | | Commercial and Business Loans | | $ | 216,552 | | | $ | 196,682 | | | $ | 152,070 | | | $ | 109,783 | | | $ | 115,831 | |
| 2 | | Government Program Loans | | | 7,029 | | | | 7,703 | | | | 3,741 | | | | 3,480 | | | | 7,889 | |
| | | Total Commercial and Industrial | | | 223,581 | | | | 204,385 | | | | 155,811 | | | | 113,263 | | | | 123,720 | |
| | | | | | | | | | | | | | | | | | | | | | | |
| 3 | | Commercial Real Estate Term Loans | | | 81,840 | | | | 102,399 | | | | 71,697 | | | | 43,644 | | | | 62,501 | |
| 4 | | Single Family Residential Loans | | | 41,608 | | | | 37,194 | | | | 39,184 | | | | 43,308 | | | | 21,567 | |
| 5 | | Home Improvement/Home Equity Loans | | | 3,241 | | | | 2,972 | | | | 2,732 | | | | 2,551 | | | | 4,119 | |
| | | Total Real Estate Mortgage | | | 126,689 | | | | 142,565 | | | | 113,613 | | | | 89,503 | | | | 88,187 | |
| | | | | | | | | | | | | | | | | | | | | | | |
| 6 | | Total Real Estate Construction Loans | | | 119,885 | | | | 178,296 | | | | 168,378 | | | | 162,873 | | | | 137,523 | |
| | | | | | | | | | | | | | | | | | | | | | | |
| 7 | | Total Agricultural Loans | | | 52,020 | | | | 46,055 | | | | 35,102 | | | | 24,935 | | | | 23,416 | |
| | | | | | | | | | | | | | | | | | | | | | | |
| 8 | | Consumer Loans | | | 20,370 | | | | 17,521 | | | | 16,327 | | | | 14,373 | | | | 12,476 | |
| 9 | | Overdraft protection Lines | | | 80 | | | | 85 | | | | 82 | | | | 102 | | | | 117 | |
| 10 | | Overdrafts | | | 332 | | | | 565 | | | | 303 | | | | 527 | | | | 664 | |
| | | Total Installment/other | | | 20,782 | | | | 18,171 | | | | 16,712 | | | | 15,002 | | | | 13,257 | |
| | | | | | | | | | | | | | | | | | | | | | | |
| 11 | | Total Lease Financing | | | 7,020 | | | | 8,748 | | | | 10,952 | | | | 12,334 | | | | 12,581 | |
| | | | | | | | | | | | | | | | | | | | | | | |
| | | Total Loans | | $ | 549,977 | | | $ | 598,220 | | | $ | 500,568 | | | $ | 417,910 | | | $ | 398,684 | |
The Company’s methodology for assessing the adequacy of the allowance for credit losses consists of several key elements, which include:
- the formula allowance,
- specific allowances for problem graded loans (“classified loans”)
- and the unallocated allowance
In addition, the allowance analysis also incorporates the results of measuring impaired loans as provided in:
- Statement of Financial Accounting Standards (“SFAS”) No. 114, “Accounting by Creditors for Impairment of a Loan” and
- SFAS 118, “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures.”
The formula allowance is calculated by applying loss factors to outstanding loans and certain unfunded loan commitments. Loss factors are based on the Company’s historical loss experience and on the internal risk grade of those loans and, may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. Factors that may affect collectibility of the loan portfolio include:
| | · | Levels of, and trends in delinquencies and nonaccrual loans; |
| | · | Trends in volumes and term of loans; |
| | · | Effects of any changes in lending policies and procedures including those for underwriting, collection, charge-off, and recovery; |
| | · | Experience, ability, and depth of lending management and staff; |
| | · | National and local economic trends and conditions and; |
| | · | Concentrations of credit that might affect loss experience across one or more components of the portfolio, including high-balance loan concentrations and participations. |
Management determines the loss factors for problem-graded loans (substandard, doubtful, and loss), special mention loans, and pass graded loans, based on a loss migration model. The migration analysis incorporates loan losses over the past twelve quarters (three years) and loss factors are adjusted to recognize and quantify the loss exposure from changes in market conditions and trends in the Company’s loan portfolio. For purposes of this analysis, loans are grouped by internal risk classifications, which are “pass”, “special mention”, “substandard”, “doubtful”, and “loss.” Certain loans are homogenous in nature and are therefore pooled by risk grade. These homogenous loans include consumer installment and home equity loans. Special mention loans are currently performing but are potentially weak, as the borrower has begun to exhibit deteriorating trends, which if not corrected, could jeopardize repayment of the loan and result in further downgrade. Substandard loans have well-defined weaknesses which, if not corrected, could jeopardize the full satisfaction of the debt. A loan classified as “doubtful” has critical weaknesses that make full collection of the obligation improbable. Classified loans, as defined by the Company, include loans categorized as substandard, doubtful, and loss. At December 31, 2008 problem graded or “classified” loans totaled $88.1 million or 16.0% of gross loans, as compared to $105.1 million or 17.3% of gross loans at September 30, 2008, and $51.8 million or 8.7% of gross loans at December 31, 2007.
Loan participations are reviewed for allowance adequacy under the same guidelines as other loans in the Company’s portfolio, with an additional participation factor added, if required, for specific risks associated with participations. In general, participations are subject to certain thresholds set by the Company, and are reviewed for geographic location as well as the well-being of the underlying agent bank.
The formula allowance includes reserves for certain off-balance sheet risks including letters of credit, unfunded loan commitments, and lines of credit. Reserves for undisbursed commitments are generally formula allocations based on the Company’s historical loss experience and other loss factors, rather than specific loss contingencies. At December 31, 2008, 2007 and 2006 the formula reserve allocated to undisbursed commitments totaled $313,000, $548,000 and $526,000, respectively.
Specific allowances are established based on management’s periodic evaluation of loss exposure inherent in classified loans, impaired loans, and other loans in which management believes there is a probability that a loss has been incurred in excess of the amount determined by the application of the formula allowance. Specific allowance amounts include those calculated under SFAS No. 114. Under SFAS No. 114, for impaired loans, specific allowances are determined based on the collateralized value of the underlying properties, the net present value of the anticipated cash flows, or the market value of the underlying assets. Under SFAS No. 5, for classified loans excluding impaired loans, specific allowances, where required, are determined on the basis of additional risks involved with individual loans that may be in excess of risk factors associated with the loan portfolio as a whole. The specific allowance is different from the formula allowance in that the specific allowance is determined on a loan-by-loan basis based on risk factors directly related to a particular loan, as opposed to the formula allowance which is determined for a pool of loans with similar characteristics, based on past historical trends and other risk factors which may be relevant on an ongoing basis.
The unallocated portion of the allowance is the result of both expected and unanticipated changes in various conditions that are not directly measured in the determination of the formula and specific allowances. The conditions may include, but are not limited to, general economic and business conditions affecting the key lending areas of the Company, credit quality trends, collateral values, loan volumes and concentrations, and other business conditions.
The following table summarizes the specific allowance, formula allowance, and unallocated allowance at December 31, 2008, September 30, 2008 and December 31, 2007.
| | | Balance | | | Balance | | | Balance | |
| (in 000's) | | December 31, 2008 | | | September 30, 2008 | | | December 31, 2007 | |
| Specific allowance – impaired loans | | $ | 8,514 | | | $ | 7,953 | | | $ | 4,452 | |
| Formula allowance – special mention and classified loans | | | 2,865 | | | | 3,860 | | | $ | 2,459 | |
| Total allowance for special mention and classified loans | | | 11,379 | | | | 11,813 | | | | 6,911 | |
| | | | | | | | | | | | | |
| Formula allowance for pass loans | | | 3,550 | | | | 3,973 | | | | 3,990 | |
| Unallocated allowance | | | 142 | | | | 320 | | | | 0 | |
| Total allowance | | $ | 15,071 | | | $ | 16,106 | | | $ | 10,901 | |
Impaired loans increased approximately $33.7 million between December 31, 2007 and December 31, 2008, and increased approximately $717,000 million during the quarter ended December 31, 2008. The specific allowance related to impaired loans increased $4.1 million and $561,000 for the year ended and quarter ended December 31, 2008, respectively. The formula allowance related to loans that are not impaired (including special mention and substandard) increased approximately $407,000 between December 31, 2007 and December 31, 2008, but decreased $995,000 during the quarter ended December 31, 2008. Increases for the year ended December 31, 2008 were the result of increases in the volume of substandard and special mention loans, as well as minor increases in adjusting factors for current economic trends and conditions, and trends in delinquent and nonaccrual loans. Even though the level of “pass” loans decreased approximately $104.2 million during the year ended December 31, 2008, the related formula allowance decreased only $441,000 during 2008 as a result of an increase in commercial and industrial loans which have a higher percentage loss allocation, as well as factor allocation increases due to current economic conditions.
At December 31, 2008, the Company segregated approximately $26.3 million of the total $33.8 million in substandard classified loans for purposes of the quarterly analysis of the adequacy of the allowance for credit losses under SFAS No. 5. Many of these loans had been downgraded to substandard because the borrowers had other direct or indirect lending relationships which were classified as substandard or impaired. The $26.3 million in substandard loans consists of ten borrowing relationships, which although classified as substandard, the Company believes are performing and therefore do not warrant the same loss factors as other substandard loans in the portfolio. The adequacy of the allowance for credit losses related to this $26.3 million pool of substandard loans was based upon current payment history, loan-to-value ratios, future anticipated performance, and other various factors. The formula allowance for credit losses related to these substandard loans totaled $1.2 million at December 31, 2008. This formula reserve is included in the formula allowance for special mention and classified loans totaling $2.9 million in the table above.
The Company’s methodology includes features that are intended to reduce the difference between estimated and actual losses. The specific allowance portion of the analysis is designed to be self-correcting by taking into account the current loan loss experience based on that portion of the portfolio. By analyzing the probable estimated losses inherent in the loan portfolio on a quarterly basis, management is able to adjust specific and inherent loss estimates using the most recent information available. In performing the periodic migration analysis, management believes that historical loss factors used in the computation of the formula allowance need to be adjusted to reflect current changes in market conditions and trends in the Company’s loan portfolio. There are a number of other factors, which are reviewed when determining adjustments in the historical loss factors. They include 1) trends in delinquent and nonaccrual loans, 2) trends in loan volume and terms, 3) effects of changes in lending policies, 4) concentrations of credit, 5) competition, 6) national and local economic trends and conditions, 7) experience of lending staff, 8) loan review and Board of Directors oversight, 9) high balance loan concentration, and 10) other business conditions. Other than the segregation of approximately $26.3 million in substandard loans at December 31, 2008 discussed above, there were no changes in estimation methods or assumptions during 2008 that affected the methodology for assessing the overall adequacy of the allowance for credit losses.
Management and the Company’s lending officers evaluate the loss exposure of classified and impaired loans on a weekly and monthly basis, and through discussions and officer meetings as conditions change. The Company’s Loan Committee meets weekly and serves as a forum to discuss specific problem assets that pose significant concerns to the Company, and to keep the Board of Directors informed through committee minutes. All special mention and classified loans are reported quarterly on Criticized Asset Reports, which are reviewed by senior management. With this information, the migration analysis and the impaired loan analysis are performed on a quarterly basis and adjustments are made to the allowance as deemed necessary. As the real estate market and economic crisis became more severe during the later part of 2008, the Company successfully worked with many of its borrowers to re-margin loans as collateral values declined, weakening the Company’s credit position and increasing the potential for losses. This process of working with potentially troubled borrowers was monitored closely through the loan review process.
Impaired loans are calculated under SFAS No. 114, and are measured based on the present value of the expected future cash flows discounted at the loan's effective interest rate or the fair value of the collateral if the loan is collateral dependent. The amount of impaired loans is not directly comparable to the amount of nonperforming loans disclosed later in this section. The primary differences between impaired loans and nonperforming loans are: i) all loan categories are considered in determining nonperforming loans while impaired loan recognition is limited to commercial and industrial loans, commercial and residential real estate loans, construction loans, and agricultural loans, and ii) impaired loan recognition considers not only loans 90 days or more past due, restructured loans and nonaccrual loans but also may include problem loans other than delinquent loans.
The Company considers a loan to be impaired when, based upon current information and events, it believes it is probable the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include nonaccrual loans, restructured debt, and performing loans in which full payment of principal or interest is not expected. Management bases the measurement of these impaired loans on the fair value of the loan's collateral or the expected cash flows on the loans discounted at the loan's stated interest rates. Cash receipts on impaired loans not performing to contractual terms and that are on nonaccrual status are used to reduce principal balances. Impairment losses are included in the allowance for credit losses through a charge to the provision, if applicable.
At December 31, 2008 and 2007, the Company's recorded investment in loans for which impairment has been recognized totaled $54.4 million and $20.6 million, respectively. Included in total impaired loans at December 31, 2008, are $31.0 million of impaired loans for which the related specific allowance is $8.5 million, as well as $23.4 million of impaired loans that as a result of write-downs or the fair value of the collateral, did not have a specific allowance. Total impaired loans at December 31, 2007 included $10.7 million of impaired loans for which the related specific allowance is $4.5 million, as well as $9.9 million of impaired loans that as a result of write-downs or the fair value of the collateral, did not have a specific allowance. The average recorded investment in impaired loans was $37.1 million, $15.9 million and $10.1 million during the years ended December 31, 2008, 2007 and 2006, respectively. In most cases, the Company uses the cash basis method of income recognition for impaired loans. In the case of certain troubled debt restructuring for which the loan is performing under the current contractual terms, income is recognized under the accrual method. For the years ended December 31, 2008 and 2007, the Company recognized no income on such loans. For the year ended December 31, 2006 the Company recognized income of $65,000 on such loans.
The greatest increase in impaired loans during the year ended December 31, 2008 has been in real estate construction loans, with that loan category comprising more than 53% of total impaired loans at December 31, 2008. Impaired construction loans decreased $10.9 million during the fourth quarter of 2008, partially as the result of the transfer of approximately $23.2 million in construction loans from impaired status to OREO during the fourth quarter of 2008.
Although construction loans are generally collateral dependent and the related collateral is considered adequate to cover the loan’s carrying value in many cases, the specific reserve related to impaired construction loans has increased approximately $1.7 million since December 31, 2007 as property valuations have declined. Specific collateral related to impaired loans is reviewed for current appraisal information, economic trends within geographic markets, loan-to-value ratios, and other factors that may impact the value of the loan collateral. Adjustments are made to collateral values as needed for these factors. Of total impaired loans, approximately $39.5 million or 72.7% are secured by real estate, and $34.0 million of total impaired loans are for the purpose of residential construction, residential and commercial acquisition and development, and land development. Residential construction loans are made for the purpose of building residential 1-4 single family homes. Residential and commercial acquisition and development loans are made for the purpose of purchasing land, and developing that land if required, and to develop real estate or commercial construction projects on those properties. Land development loans are made for the purpose of converting raw land into construction-ready building sites. The following table summarizes the components of impaired loans and their related specific reserves at December 31, 2008, September 30, 2008 and December 31, 2007.
| | | Balance | | | Reserve | | | Balance | | | Reserve | | | Balance | | | Reserve | |
| (in 000’s) | | December 31, 2008 | | | December 31, 2008 | | | Sept 30, 2008 | | | Sept 30, 2008 | | | December 31, 2007 | | | December 31, 2007 | |
| Commercial and industrial | | $ | 12,244 | | | $ | 2,340 | | | $ | 7,831 | | | $ | 294 | | | $ | 7,617 | | | $ | 339 | |
| Real estate – mortgage | | | 3,689 | | | | 226 | | | | 600 | | | | 0 | | | | 0 | | | | 0 | |
| Real estate – construction | | | 28,927 | | | | 2,338 | | | | 39,799 | | | | 4,133 | | | | 7,474 | | | | 598 | |
| Agricultural | | | 4,086 | | | | 68 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | |
| Installment/other | | | 0 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | |
| Lease financing | | | 5,425 | | | | 3,542 | | | | 5,425 | | | | 3,526 | | | | 5,536 | | | | 3,516 | |
| Total | | $ | 54,371 | | | $ | 8,514 | | | $ | 53,655 | | | $ | 7,953 | | | $ | 20,627 | | | $ | 4,453 | |
Of the $28.9 million in impaired construction loans shown above at December 31, 2008, approximately $13.6 million or 25.1% are for residential construction $15.3 million or 28.1 % are for land development. Of the $12.2 million in impaired commercial and industrial loans at December 31, 2008, more than $1.8 million or 14.7% are for residential construction. Geographically, the $34.0 million in impaired loans made for the purpose of residential construction, residential and commercial acquisition and development, and land development, are disbursed throughout a wide area of California, with approximately 27.4% of those loans within Fresno, Madera, Kern, and Santa Clara Counties. The following table summarizes the impaired loan balances by county of loans made for the purpose of residential construction, residential and commercial acquisition and development, and land development as of December 31, 2008.
| | | Impaired | | | | |
| County: | | Balance (000's) | | | Percentage | |
| Fresno | | $ | 229 | | | | 0.67 | % |
| Madera | | | 2,923 | | | | 8.61 | % |
| Kern | | | 4,991 | | | | 14.70 | % |
| Santa Clara | | | 1,161 | | | | 3.42 | % |
| Alpine | | | 7,973 | | | | 23.49 | % |
| San Mateo | | | 2,103 | | | | 6.19 | % |
| Mariposa | | | 1,084 | | | | 3.19 | % |
| Merced | | | 2,524 | | | | 7.43 | % |
| Monterey | | | 7,781 | | | | 22.92 | % |
| Sacramento | | | 1,425 | | | | 4.20 | % |
| Sonoma | | | 1,156 | | | | 3.41 | % |
| Other counties | | | 600 | | | | 1.77 | % |
| Total R.E. related impaired | | $ | 33,950 | | | | 100.00 | % |
The Company focuses on competition and other economic conditions within its market area and other geographical areas in which it does business, which may ultimately affect the risk assessment of the portfolio. The Company continues to experience increased competition from major banks, local independents and non-bank institutions creating pressure on loan pricing. With interest rates decreasing 100 basis points during the fourth quarter of 2007, another 400 basis points during 2008, indications are that the economy will continue to suffer in the near future as a result of sub-prime lending problems, a weakened real estate market, and tight credit markets. Both business and consumer spending have slowed during the past several quarters, and current GDP projections for the next year have softened significantly. It is difficult to determine to what degree the Federal Reserve will adjust short-term interest rates in its efforts to influence the economy, or what magnitude government economic support programs will reach. It is likely that the business environment in California will continue to be influenced by these domestic as well as global events. The local market has remained relatively more stable economically during the past several years than other areas of the state and the nation, which have experienced more volatile economic trends, including significant deterioration of residential real estate markets. Although the local area residential housing markets have been hit hard, they continue to perform better than other parts of the state, which should bode well for sustained, but slower growth in the Company’s market areas of Fresno and Madera, Kern, and Santa Clara Counties. Local unemployment rates in the San Joaquin Valley remain high primarily as a result of the areas’ agricultural dynamics, however unemployment rates have increased recently as the national economy has declined. It is difficult to predict what impact this will have on the local economy. The Company believes that the Central San Joaquin Valley will continue to grow and diversify as property and housing costs remain reasonable relative to other areas of the state. Management recognizes increased risk of loss due to the Company's exposure from local and worldwide economic conditions, as well as potentially volatile real estate markets, and takes these factors into consideration when analyzing the adequacy of the allowance for credit losses.
The following table provides a summary of the Company's allowance for credit losses, provisions made to that allowance, and charge-off and recovery activity affecting the allowance for the years indicated.
| | | December 31, | |
| (Dollars in thousands) | | 2008 | | | 2007 | | | 2006 | | | 2005 | | | 2004 | |
| Total loans outstanding at end of period before | | | | | | | | | | | | | | | |
| deducting allowances for credit losses | | $ | 548,742 | | | $ | 596,480 | | | $ | 499,570 | | | $ | 417,156 | | | $ | 397,584 | |
| Average net loans outstanding during period | | $ | 587,925 | | | $ | 580,873 | | | $ | 469,959 | | | $ | 402,820 | | | $ | 374,748 | |
| | | | | | | | | | | | | | | | | | | | | |
| Balance of allowance at beginning of period | | $ | 10,901 | | | $ | 8,365 | | | $ | 7,748 | | | $ | 7,251 | | | $ | 6,081 | |
| Loans charged off: | | | | | | | | | | | | | | | | | | | | |
| Real estate | | | (3,103 | ) | | | (22 | ) | | | 0 | | | | 0 | | | | 0 | |
| Commercial and industrial | | | (1,890 | ) | | | (4,286 | ) | | | (290 | ) | | | (323 | ) | | | (14 | ) |
| Lease financing | | | (281 | ) | | | (8 | ) | | | (164 | ) | | | (364 | ) | | | (496 | ) |
| Installment and other | | | (271 | ) | | | (177 | ) | | | (48 | ) | | | (86 | ) | | | (80 | ) |
| Total loans charged off | | | (5,545 | ) | | | (4,493 | ) | | | (502 | ) | | | (773 | ) | | | (590 | ) |
| Recoveries of loans previously charged off: | | | | | | | | | | | | | | | | | | | | |
| Real estate | | | 0 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | |
| Commercial and industrial | | | 92 | | | | 46 | | | | 195 | | | | 108 | | | | 82 | |
| Lease financing | | | 14 | | | | 0 | | | | 1 | | | | 3 | | | | 29 | |
| Installment and other | | | 11 | | | | 18 | | | | 43 | | | | 54 | | | | 25 | |
| Total loan recoveries | | | 117 | | | | 64 | | | | 239 | | | | 165 | | | | 136 | |
| Net loans charged off | | | (5,428 | ) | | | (4,429 | ) | | | (263 | ) | | | (608 | ) | | | (454 | ) |
| | | | | | | | | | | | | | | | | | | | | |
| Reclassification of off-balance sheet reserve | | | 0 | | | | 0 | | | | 0 | | | | (35 | ) | | | (507 | ) |
| Reserve acquired in business acquisition | | | 0 | | | | 1,268 | | | | 0 | | | | 0 | | | | 986 | |
| Provision charged to operating expense | | | 9,598 | | | | 5,697 | | | | 880 | | | | 1,140 | | | | 1,145 | |
| Balance of allowance for credit losses | | | | | | | | | | | | | | | | | | | | |
| at end of period | | $ | 15,071 | | | $ | 10,901 | | | $ | 8,365 | | | $ | 7,748 | | | $ | 7,251 | |
| | | | | | | | | | | | | | | | | | | | | |
| Net loan charge-offs to total average loans | | | 0.92 | % | | | 0.76 | % | | | 0.06 | % | | | 0.15 | % | | | 0.12 | % |
| Net loan charge-offs to loans at end of period | | | 0.99 | % | | | 0.74 | % | | | 0.05 | % | | | 0.15 | % | | | 0.11 | % |
| Allowance for credit losses to total loans at end of period | | | 2.75 | % | | | 1.83 | % | | | 1.67 | % | | | 1.86 | % | | | 1.82 | % |
| Net loan charge-offs to allowance for credit losses | | | 36.02 | % | | | 40.63 | % | | | 3.14 | % | | | 7.85 | % | | | 6.26 | % |
| Net loan charge-offs to provision for credit losses | | | 56.55 | % | | | 77.74 | % | | | 29.89 | % | | | 53.33 | % | | | 39.65 | % |
Management believes that the 2.75% credit loss allowance to total loans at December 31, 2008 is adequate to absorb known and inherent risks in the loan portfolio. No assurance can be given, however, that the economic conditions which may adversely affect the Company's service areas or other circumstances will not be reflected in increased losses in the loan portfolio. Management is not currently aware of any conditions that may adversely affect the levels of losses incurred in the Company’s loan portfolio.
Although the Company does not normally allocate the allowance for credit losses to specific loan categories, an allocation to the major categories has been made for the purposes of this report as set forth in the following table. The allocations are estimates based on the same factors as considered by management in determining the amount of additional provisions to the credit loss allowance and the overall adequacy of the allowance for credit losses.
| | | 2008 | | | 2007 | | | 2006 | | | 2005 | | | 2004 | |
| | | Allowance | | | | | | Allowance | | | | | | Allowance | | | | | | Allowance | | | | | | Allowance | | | | |
| | | for Credit | | | % of | | | for Credit | | | % of | | | For Credit | | | % of | | | for Credit | | | % of | | | for Credit | | | % of | |
(Dollars in thousands) | | Losses | | | Loans | | | Losses | | | Loans | | | Losses | | | Loans | | | Losses | | | Loans | | | Losses | | | Loans | |
| Commercial and industrial | | $ | 5,829 | | | | 40.7 | % | | $ | 3,254 | | | | 34.2 | % | | $ | 1,905 | | | | 31.1 | % | | $ | 1,397 | | | | 27.1 | % | | $ | 2,497 | | | | 31.0 | % |
| Real estate – mortgage | | | 715 | | | | 23.0 | % | | | 593 | | | | 23.8 | % | | | 619 | | | | 22.7 | % | | | 330 | | | | 21.4 | % | | | 386 | | | | 22.1 | % |
| Real estate – construction | | | 3,658 | | | | 21.7 | % | | | 2,824 | | | | 29.8 | % | | | 1,039 | | | | 33.7 | % | | | 1,598 | | | | 38.9 | % | | | 1,753 | | | | 34.5 | % |
| Agricultural | | | 1,035 | | | | 9.5 | % | | | 559 | | | | 7.7 | % | | | 310 | | | | 7.0 | % | | | 316 | | | | 6.0 | % | | | 197 | | | | 5.9 | % |
| Installment/other | | | 101 | | | | 3.8 | % | | | 133 | | | | 3.0 | % | | | 187 | | | | 3.3 | % | | | 112 | | | | 3.6 | % | | | 103 | | | | 3.3 | % |
| Lease financing | | | 3,591 | | | | 1.3 | % | | | 3,538 | | | | 1.5 | % | | | 4,165 | | | | 2.2 | % | | | 3,619 | | | | 3.0 | % | | | 2,312 | | | | 3.2 | % |
| Not allocated | | | 142 | | | | — | | | | 0 | | | | — | | | | 140 | | | | — | | | | 376 | | | | — | | | | 3 | | | | — | |
| | | $ | 15,071 | | | | 100.0 | % | | $ | 10,901 | | | | 100.0 | % | | $ | 8,365 | | | | 100.0 | % | | $ | 7,748 | | | | 100.0 | % | | $ | 7,251 | | | | 100.0 | % |
During 2008, reserve allocations increased significantly for commercial and industrial loans, and to lesser extent, construction and agricultural loans. As with prior years, the significant reserve allocation for lease financing loans is the result of specific reserves allocated to a lease portfolio that has been nonperforming since 2002 and is in the process of litigation (see discussion following). Increased reserve allocations for commercial and industrial loans, construction loans, as well as agricultural loans, are the result of increases in special mention and substandard loans in those categories, with an increase in the volume of loans considered impaired. Successful re-margining of a number of the Company’s problem loans during the third and fourth quarters of 2008 helped to reduce potential loss exposure in the loan portfolio.
During 2007, reserve allocations increased significantly for commercial and industrial loans, construction loans, and to lesser extent, agricultural loans. Increased reserve allocations for commercial and industrial loans, as well as agricultural loans are the result of increased loan volume, as well as increases in substandard loans in those categories. Increases in reserve allocations for construction loans are primarily the result of increases in special mention and substandard loans in those categories. Reserve allocations decreased for lease financing loans as a result of positive results in the litigation process related to the Company’s nonperforming purchased lease portfolio.
During 2006, reserve allocations increased for commercial and industrial loans, leasing financing, real estate mortgage loans, and installment loans. Increased reserve allocations for commercial and industrial loans are the result of increased loan volume, while increases in reserve allocations for real estate mortgage and installment loans are primarily the result of increases in substandard loans in those categories. Reserve allocations decreased for real estate construction loans as a result of significant decreases in the level of substandard loans in that category between December 31, 2005 and December 31, 2006.
The Company believes that under generally accepted accounting principles, a total loss of principal is not probable at this time and the specific allowance of $3.5 million calculated for the impaired lease portfolio at December 31, 2008 under SFAS No. 114 is in accordance with GAAP.
During a regulatory examination in the fourth quarter of 2003, the lease portfolio in question was classified as doubtful by the Bank’s regulators based upon state regulatory guidelines. California Financial Code No. 1951 requires that a credit, where interest is past due and unpaid for more than one year and is not well secured and not in the process of collection, be charged off. The regulators requested that the Bank charge-off the principal balance in the first or second quarter of 2004 for regulatory purposes if the judge had not made a ruling on the case by March 31, 2004 or, if a ruling had been made but no principal payments have been received by June 30, 2004. The court did not rule by March 31, 2004, and has not made a final ruling on the case at the time of this 10-K filing. As a result, effective March 31, 2004, the Company charged off the entire $5.5 million principal balance for regulatory purposes. As a result of the regulatory charge-off, the Company carries a difference between its regulatory accounting principles (RAP) books and its generally accepted accounting principles (GAAP) books. The financial entries made for regulatory reporting purposes resulted in a $5.5 million reduction in loan balances with a corresponding reduction in the reserve for credit losses. Additional provisions for credit losses of $3.5 million were also required for regulatory accounting purposes, which resulted in a reduction of $2.1 million in regulatory net income (net tax benefit of $1.3 million) for the year ended December 31, 2004 as compared to the financial statements presented under GAAP in the Company’s 2004 Annual Report on Form 10-K.
The following summarizes the Company’s allowance for credit losses related to the specific, formula, and unallocated reserves for the year-ends shown:
| | | December 31, | |
| (Dollars in 000’s) | | 2008 | | | 2007 | | | 2006 | | | 2005 | | | 2004 | |
| Formula allowance | | $ | 3,550 | | | $ | 3,990 | | | $ | 3,637 | | | $ | 2,976 | | | $ | 2,827 | |
| Specific allowance | | | 11,379 | | | | 6,911 | | | | 4,588 | | | | 4,396 | | | | 4,421 | |
| Unallocated allowance | | | 142 | | | | 0 | | | | 140 | | | | 376 | | | | 3 | |
| Total allowance | | $ | 15,071 | | | $ | 10,901 | | | $ | 8,365 | | | $ | 7,748 | | | $ | 7,251 | |
At December 31, 2008, the allowance for credit losses totaled $15.1 million, and consisted of $3.6 million in formula allowance, $11.4 million in specific allowance, and $142,000 in unallocated reserve. At December 31, 2008, $3.6 million of the specific allowance was allocated to lease financing loans, and the remaining $3.7 million, $3.0 million, $801,000, $215,000, and $91,000 were allocated to commercial and industrial loans, real estate construction loans, agricultural loans, commercial real estate loans, residential real estate loans, respectively.
At December 31, 2007, the allowance for credit losses totaled $10.9 million, and consisted of $4.0 million in formula allowance, and $6.9 million in specific allowance. At December 31, 2007, $3.5 million of the specific allowance was allocated to lease financing loans, and the remaining $40,000, $311,000, $38,000, $1.0 million and $2.0 million were allocated to commercial real estate, agricultural, installment, commercial and industrial loans, and real estate construction loans, respectively.
The allowance for credit losses totaled $8.4 million at December 31, 2006, and consisted of $3.6 million in formula allowance, $4.6 million in specific allowance, and $140,000 in unallocated allowance. At December 31, 2006, $4.0 million of the specific allowance was allocated to lease financing loans, and the remaining $227,000, $111,000, $76,000, $69,000 and $58,000 were allocated to commercial real estate, agricultural, installment, commercial and industrial loans, and real estate construction loans, respectively.
The total formula allowance decreased approximately $440,000 between 2007 and 2008, primarily as the result of decreased volume in “pass” loans. The formula allowance for construction loans decreased $262,000 during 2008, and the decreased $131,000 for commercial real estate loans, wit only minor changes in other loan categories. Between December 31, 2007 and December 31, 2008, sub-substandard loans increased $34.8 million, while special mention and doubtful loans increased $21.1 million and $1.6 million, respectively. Increases in loan downgrades experienced during 2008 were primarily the result of continued deterioration in the overall economy, including the residential construction market, which in turn has impacted other sectors of the lending portfolio.
The total formula allowance increased approximately $353,000 between 2006 and 2007, primarily as the result of increased volume in “pass” loans. There were only minor formula allowance allocation changes between loan categories occurring between December 31, 2006 and December 31, 2007, and so most changes in the formula allowance during 2007 were the result of volume changes. Between December 31, 2006 and December 31, 2007, sub-substandard loans increased $35.0 million, while special mention and doubtful loans increased $8.6 million and $891,000 million, respectively. Increases in loan downgrades experienced during 2007 were primarily the result of deteriorating economic factors in the residential construction market, which in turn has impacted other sectors of the lending portfolio.
Although in some instances, the downgrading of a loan resulting from the factors used by the Company in its allowance analysis has been reflected in the formula allowance, management believes that in some instances, the impact of material events and trends has not yet been reflected in the level of nonperforming loans or the internal risk grading process regarding these loans. Accordingly, the Company’s evaluation of probable losses related to these factors may be reflected in the unallocated allowance. The evaluation of the inherent losses concerning these factors involve a higher degree of uncertainty because they are not identified with specific problem credits, and therefore the Company does not spread the unallocated allowance among segments of the portfolio. At December 31, 2008, the Company had an unallocated allowance of $142,000. At December 31, 2007 the Company had no unallocated allowance, reflecting a decrease from the balance of $140,000 at December 31, 2006. Management’s estimates of the unallocated allowance are based upon a number of underlying factors including 1) the effect of deteriorating national and local economic trends, 2) the effects of export market conditions on certain agricultural and manufacturing borrowers, 3) the effects of abnormal weather patterns on agricultural borrowers, as well as other borrowers that may be impacted by such conditions, 4) the effect of increased competition in the Company’s market area and the resultant potential impact of more relaxed underwriting standards to borrowers with multi-bank relationships, 5) the effect of soft real estate markets, and 6) the effects of having a larger number of borrowing relationships which are close to the Company’s lending limit, any one if which were not to perform to contractual terms, would have a material impact on the allowance.
The Company's loan portfolio has concentrations in commercial real estate, commercial, and construction loans, however these portfolio percentages fall within the Company's loan policy guidelines.
It is the Company's policy to discontinue the accrual of interest income on loans for which reasonable doubt exists with respect to the timely collectibility of interest or principal due to the inability of the borrower to comply with the terms of the loan agreement. Such loans are placed on nonaccrual status whenever the payment of principal or interest is 90 days past due or earlier when the conditions warrant, and interest collected is thereafter credited to principal to the extent necessary to eliminate doubt as to the collectibility of the net carrying amount of the loan. Management may grant exceptions to this policy if the loans are well secured and in the process of collection.
The following table sets forth the Company’s nonperforming assets as of the dates indicated:
| | | December 31, | |
(Dollars in thousands, except footnote) | | 2008 | | | 2007 | | | 2006 | | | 2005 | | | 2004 | |
| Nonaccrual loans (1) | | $ | 51,096 | | | $ | 21,583 | | | $ | 8,138 | | | $ | 13,930 | | | $ | 16,682 | |
| Restructured loans | | | 0 | | | | 23 | | | | 4,906 | | | | 0 | | | | 0 | |
| Total non-performing loans | | | 51,096 | | | | 21,606 | | | | 13,044 | | | | 13,930 | | | | 16,682 | |
| Other real estate owned | | | 30,153 | | | | 6,666 | | | | 1,919 | | | | 4,356 | | | | 1,615 | |
| Total non-performing assets | | $ | 81,249 | | | $ | 28,272 | | | $ | 14,963 | | | $ | 18,286 | | | $ | 18,297 | |
| | | | | | | | | | | | | | | | | | | | | |
| Loans, past due 90 days or more, still accruing | | $ | 680 | | | $ | 189 | | | $ | 0 | | | $ | 0 | | | $ | 375 | |
| | | | | | | | | | | | | | | | | | | | | |
| Non-performing loans to total gross loans | | | 9.29 | % | | | 3.61 | % | | | 2.61 | % | | | 3.33 | % | | | 4.18 | % |
| Non-performing assets to total gross loans | | | 14.77 | % | | | 4.73 | % | | | 2.99 | % | | | 4.38 | % | | | 4.59 | % |
| (1) | Included in nonaccrual loans at December 31, 2008 are restructured loans totaling $378,000. There were no nonaccrual loans at December 31, 2007 and 2006, which are restructured. The interest income that would have been earned on nonaccrual loans outstanding at December 31, 2008 in accordance with their original terms is approximately $3.7 million. |
Non-performing assets have increased between December 31, 2007 and December 31, 2008 as declines in real estate markets and related sectors experienced since the later part of 2007 resulting from lending problems continued to impact credit markets and the general economy throughout 2008. Nonaccrual loans increased $29.5 million between December 31, 2007 and December 31, 2008, with construction loans comprising approximately 57% of total nonaccrual loans at December 31, 2008, and commercial and industrial loans comprising another 19%. The following table summarizes the nonaccrual totals by loan category for the periods shown..
Non-performing assets increased between December 31, 2006 and December 2007 as housing markets and related sectors experienced declines during the second half of the year as a result of sub-prime lending problems which impacted credit markets and the overall economy worldwide. Economic conditions in the San Joaquin Valley remained strong during much of 2007, although as a result of the decline in the housing sector and related real estate valuations, nonperforming assets increased during the years and additional charge-offs were taken during the third and fourth quarters of 2007. Non-performing assets increased during 2007, totaling 4.73% of total loans at December 31, 2007 as compared to 2.99% of total loans at December 31, 2006. Non-performing loans, a component of non-performing assets, increased nearly $8.6 million during 2007 primarily as the result of real estate construction and real estate development loans which become impaired during the period. Some, but not all, of these nonperforming real estate credits were outside the Company’s immediate market area, specifically Southern California and the San Francisco Bay area.
The following table summarizes the nonaccrual totals by loan category for the periods shown:
| | | Balance | | | Balance | | | Balance | | | Change from | | | Change from | |
| Nonaccrual Loans (in 000's): | | December 31, 2008 | | | September 30, 2008 | | | December 31, 2007 | | | September 30, 2008 | | | December 31, 2007 | |
| Commercial and industrial | | $ | 9,507 | | | $ | 8,766 | | | $ | 6,372 | | | $ | 741 | | | $ | 3,135 | |
| Real estate - mortgage | | | 3,714 | | | | 1,747 | | | | 428 | | | | 1,967 | | | | 3,286 | |
| Real estate - construction | | | 28,927 | | | | 39,088 | | | | 7,548 | | | | (10,161 | ) | | | 21,379 | |
| Agricultural | | | 3,406 | | | | 0 | | | | 1,684 | | | | 3,406 | | | | 1,722 | |
| Installment/other | | | 55 | | | | 20 | | | | 3 | | | | 35 | | | | 52 | |
| Lease financing | | | 5,486 | | | | 5,495 | | | | 5,548 | | | | (9 | ) | | | (62 | ) |
| Total Nonaccrual Loans | | $ | 51,095 | | | $ | 55,116 | | | $ | 21,583 | | | $ | (4,021 | ) | | $ | 29,512 | |
Increases in nonaccrual construction loans between December 31, 2007 and December 31, 2008 are the result of a significant slowdown in new housing starts and the resultant depreciation in land, and both partially completed and completed construction projects. Nonaccrual construction loans decreased $10.2 million during the fourth quarter of 2008, primarily as the result of construction loans that were transferred to other real estate owned. As with impaired loans, a large percentage of nonaccrual loans were made for the purpose of residential construction, residential and commercial acquisition and development, and land development. The following table summarizes nonaccrual balances by purpose at December 31, 2008.
| (in 000's) | | December 31, 2008 | |
| Residential construction | | $ | 17,386 | |
Residential and commercial acquisition and development | | | 450 | |
| Land development | | | 16,043 | |
| Other purposes | | | 17,217 | |
| Total nonaccrual loans | | $ | 51,096 | |
During the nine months ended September 30, 2008, five loans totaling approximately $2.7 million were transferred from nonaccrual status to other real estate owned, and during the quarter ended December 31, 2008, an additional nine loans totaling $25.7 million were transferred to other real estate owned, bringing the total OREO balance to $31.2 million at December 31, 2008. Charges to the reserve for loan and lease losses at the time of transfer to other real estate owned to record the underlying collateral at fair value totaled $2.5 million for the year ended December 31, 2008. Non-performing assets totaled 10.68% of total loans at December 31, 2008 as compared to 4.73% of total loans at December 31, 2007.
A nonaccrual land development loan transferred to other real estate owned during the fourth quarter of 2007 with a principal balance of $6.0 million and accrued interest of $865,000 ($6.9 million total) is a shared appreciation credit, and as such, the Company agreed to receive interest on the loan as lots sold rather than monthly, and the borrower agreed to share in the profits of the project. Interest was accrued and recognized in income on an ongoing basis. Upon moving the credit to nonaccrual status during the first quarter of 2007, the Company ceased to accrue additional interest on the loan and continued to carry, on its books, the previously accrued interest amount of $865,000, because it was supported by the most recent appraised value of the property at that time plus an added value for the recording of the approved map for the 177 lots which was imminent. Upon foreclosure and transfer to other real estate owned during the fourth quarter of 2007, the Company obtained an updated appraisal to determine the current fair value of the property. As a result of significant deterioration in the housing markets during this period, the Company adjusted the carrying value of the property down by $2.4 million during the fourth quarter of 2007 with a charge against the allowance for credit losses.
Other real estate owned through foreclosure increased to $6.7 million or 0.86% of total assets at December 31, 2007, as compared to $1.9 million or 0.28% of total assets at December 31, 2006. During 2007, three properties with net collateral value totaling $5.3 million were transferred from nonaccrual loans, one of which was subsequently sold during the year. The Company increased its focus on the resolution of impaired assets during the later part of 2007 and will continue to do so until nonperforming assets return to minimal levels.
A $4.9 million loan classified as restructured at December 31, 2006, paid off during the first quarter of 2007, resulting in the recognition of approximately $1.1 million in previously unrecognized interest income during 2007, and the overall reduction of restructured loans at December 31, 2007
Loans past due more than 30 days are receiving increased management attention and are monitored for increased risk. The Company continues to move past due loans to nonaccrual status in its ongoing effort to recognize loan problems at an earlier point in time when they may be dealt with more effectively. As impaired loans, nonaccrual and restructured loans are reviewed for specific reserve allocations and the allowance for credit losses is adjusted accordingly.
Except for the loans included in the above table, and the land development loan discussed above, there were no loans at December 31, 2008 where the known credit problems of a borrower caused the Company to have serious doubts as to the ability of such borrower to comply with the present loan repayment terms and which would result in such loan being included as a nonaccrual, past due or restructured loan at some future date.
Liquidity and Asset/Liability Management
The primary function of asset/liability management is to provide adequate liquidity and maintain an appropriate balance between interest-sensitive assets and interest-sensitive liabilities.
Liquidity
Liquidity management may be described as the ability to maintain sufficient cash flows to fulfill both on- and off-balance sheet financial obligations, including loan funding commitments and customer deposit withdrawals, without straining the Company’s equity structure. To maintain an adequate liquidity position, the Company relies on, in addition to cash and cash equivalents, cash inflows from deposits and short-term borrowings, repayments of principal on loans and investments, and interest income received. The Company's principal cash outflows are for loan origination, purchases of investment securities, depositor withdrawals and payment of operating expenses. Other sources of liquidity not on the balance sheet at December 31, 2008 include unused collateralized and uncollateralized lines of credit from other banks, the Federal Home Loan Bank, and from the Federal Reserve Bank totaling $184.8 million.
Cash and cash equivalents have declined during the three years ended December 31, 2008, 2007, and 2006, with period-end balances as follows (from Consolidated Statements of Cash Flows – in 000’s):
| | | Balance | |
| December 31, 2008 | | $ | 19,426 | |
| December 31, 2007 | | $ | 25,300 | |
| December 31, 2006 | | $ | 43,068 | |
| December 31, 2005 | | $ | 63,030 | |
Cash and cash equivalents decreased $5.9 million during the year ended December 31, 2008, as compared to a decrease of $17.8 million and $20.0 million during the years ended December 31, 2007 and 2006, respectively.
The Company has maintained positive cash flows from operations over the past three years, which amounted to $12.6 million, $19.0 million, and $16.2 million for the years ended December 31, 2008, 2007, and 2006, respectively.
The Company experienced net cash outflows from investing activities totaling $9.4 million during the year ended December 31, 2008, as purchases of investment securities interest-bearing deposits in other banks exceeded net loan payoffs and maturities of investment securities during the period. The Company experienced net cash outflows from investing activities totaling $30.5 million and $69.8 million during the years ended December 31, 2007 and 2006, respectively, as loan growth has exceeded net maturities of investment securities as well as other investment instruments during those years.
Net cash flows from financing activities, including deposit growth and borrowings, have traditionally provided funding sources for loan growth, but during 2008 and 2007 the Company experienced net cash outflows totaling $9.1 million and $6.3 million, respectively, as declines in net deposit accounts, as well as repurchases of the Company’s common stock, exceeded growth in financing categories, including borrowings. The Company has the ability to decrease loan growth, increase deposits and borrowings, or a combination of both to manage balance sheet liquidity.
Liquidity risk arises from the possibility the Company may not be able to satisfy current or future financial commitments, or the Company may become unduly reliant on alternative funding sources. The Company maintains a liquidity risk management policy to address and manage this risk. The policy identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements, which comply with regulatory guidance. The liquidity position is continually monitored and reported on a monthly basis to the Board of Directors.
The policy also includes a contingency funding plan to address liquidity needs in the event of an institution-specific or a systemic financial market crisis. In addition to unused lines of credit from other banks totaling $184.8 million, the contingency plan includes steps that may be taken in the event the total liquidity ratio falls or is projected to fall below 15% for any extended period of time. The Bank ALCO committee shall take steps to correct this condition using one or more of the following methods as needed:
| | 1) | Investments near maturity may be sold to meet temporary funding needs but may need to be replaced to maintain liquidity ratios within acceptable limits. |
| | 2) | Unsecured Fed Funds lines with correspondents may be used to fund short-term peaks in loan demand or deposit run-off. Other off-balance sheet funding sources such as credit lines at FHLB or the FRB may be used for longer periods. |
| | 3) | The Bank will not rely on brokered money as a primary source of funds. However, if may be prudent to utilize brokered deposits particularly at times when the interest costs are lower than could be obtained in the local market. However, the sum of all brokered deposits will not exceed 15% of the total deposits of the Bank. |
| | 4) | The Bank may elect to operate a Telemarketing Money Desk for the purpose of acquiring Certificates of Deposits from both the local market and national market. The Board of Directors and management recognize that deposits acquired through money desk operations may be considered a higher cost and more volatile type of deposit than traditional bank deposits. |
| | 5) | Selling whole loans or participation in loans or by increasing the amounts sold in existing participation loans are additional means for increasing liquidity. |
| | 6) | The State of California Treasurer is a reliable source of deposits. The bank can typically accept CD’s from this source up to 90% of equity as long as it has sufficient collateral pledged. |
| | 7) | Marketing for CD’s within our marketplace is another means for raising funds or through programs that post our rates on their Website, deposits from these sources should not exceed 15% of the banks total deposits for extended periods beyond 90 days without board approval. |
| | 8) | Should the Bank become illiquid in spite of these steps, it will curtail its lending activities. The first step in this process will be to curtail credit marketing and tighten pricing guidelines. The second step will be to encourage loan payoffs on a selective basis where circumstances and loan documentation provide this opportunity. Only as a last resort will the Bank totally curtail lending activities to credit worthy customers. |
The Company continues to utilize liability management, when needed, as part of its overall asset/liability management strategy. Through the discretionary acquisition of short term borrowings, the Company has been able to provide liquidity to fund asset growth while, at the same time, better utilizing its capital resources, and better controlling interest rate risk. The borrowings are generally short-term and more closely match the repricing characteristics of floating rate loans, which comprise approximately 64.0% of the Company’s loan portfolio at December 31, 2008. This does not preclude the Company from selling assets such as investment securities to fund liquidity needs but, with favorable borrowing rates, the Company has maintained a positive yield spread between borrowed liabilities and the assets which those liabilities fund. If, at some time, rate spreads become unfavorable, the Company has the ability to utilize an asset management approach and, either control asset growth or, fund further growth with maturities or sales of investment securities.
The Company's liquid asset base which generally consists of cash and due from banks, federal funds sold, securities purchased under agreements to resell (“reverse repos”) and investment securities, is maintained at a level deemed sufficient to provide the cash outlay necessary to fund loan growth as well as any customer deposit runoff that may occur. Within this framework is the objective of maximizing the yield on earning assets. This is generally achieved by maintaining a high percentage of earning assets in loans, which historically have represented the Company's highest yielding asset. At December 31, 2008, the Bank had 70.1% of total assets in the loan portfolio and a loan-to-deposit ratio of 107.9%. Liquid assets at December 31, 2008 include cash and cash equivalents totaling $19.4 million as compared to $25.3 million at December 31, 2007.
Liabilities used to fund liquidity sources include core and non-core deposits as well as short-term borrowings. Core deposits, which comprise approximately 71.9% of total deposits at December 31, 2008, provide a significant and stable funding source for the Company. At December 31, 2008, unused lines of credit with the Federal Home Loan Bank and the Federal Reserve Bank totaling $153.3 million are collateralized in part by certain qualifying loans in the Company’s loan portfolio. The carrying value of loans pledged on these used and unused borrowing lines totaled $327.5 million at December 31, 2008. For further discussion of the Company’s borrowing lines, see “Short Term Borrowings” included in previously in the financial condition section of this financial review.
Enacted during 2008 as part of the government’s Emergency Economic Stabilization Act, TARP (Treasury Asset Recovery Program) is a voluntary program established only for healthy financial institutions. In order to receive TARP capital, institutions must undergo an extensive review by their primary regulator and the U.S. Treasury Department. Along with high rates of interest, TARP capital comes with restrictions, including a U.S. Treasury Department right to buy shares (warrants) in the Company, and significant oversight requirements. At this time, the Company has not used TARP monies to increase capital.
The liquidity of the parent company, United Security Bancshares, is primarily dependent on the payment of cash dividends by its subsidiary, United Security Bank, subject to limitations imposed by the Financial Code of the State of California. During 2008 and 2007, total dividends paid by the Bank to the parent company totaled $4.3 million and $17.6 million, respectively. The Company currently believes the Bank has the ability in the future to pay sufficient cash dividends to the Company to cover its ongoing cash requirements including quarterly interest payments on its junior subordinated debt. As a bank holding company formed under the Bank Holding Act of 1956, United Security Bancshares continues to provide a source of financial strength for its subsidiary bank(s). To help provide financial strength to the Bank, United Security Bancshares’ trust subsidiary, United Security Bancshares Capital Trust I completed a $15 million offering in Trust Preferred Securities during 2001, the proceeds of which were used to purchase Junior Subordinated Debentures of the Company. Of the $14.5 million in net proceeds received by the Company, $13.7 million in cash was contributed as capital to United Security Bank enhancing the liquidity and capital positions of the Bank, and the remainder provided liquidity to the holding company. The Trust Preferred Securities issued under United Security Bancshares Capital Trust I were redeemed during July 2007, and subsequently, new Trust Preferred Securities totaling $15 million were issued under United Security Bancshares Capital Trust II. The issuance of the new Trust Preferred Securities reduced the Company’s cost of the debt by 246 basis points.
Contractual Obligations, Commitments, Contingent Liabilities, and Off-Balance Sheet Arrangements
The following table presents, as of December 31, 2008, the Company's significant fixed and determinable contractual obligations by payment date. The payment amounts represent those amounts contractually due to the recipient and do not include any unamortized premiums or discounts, or other similar carrying value adjustments. Further discussion of the nature of each obligation is included in the referenced note to the consolidated financial statements.
| | | | | | Payments Due In | | | | |
(In thousands) | | Note Reference | | | One Year Or Less | | | One to Three Years | | | Three to Five Years | | | Over Five Years | | | Total | |
| Deposits without a stated maturity | | | 7 | | | $ | 323,727 | | | $ | — | | | $ | — | | | $ | — | | | $ | 323,727 | |
| Time Deposits | | | 7 | | | | 172,730 | | | | 11,230 | | | | 788 | | | | 11 | | | | 184,759 | |
| FHLB Borrowings | | | 8 | | | | 77,500 | | | | 11,000 | | | | | | | | | | | | 88,500 | |
| Junior Subordinated Debt (at FV) | | | 9, 10 | | | | | | | | | | | | | | | | 11,926 | | | | 11,926 | |
| Operating Leases | | | 14 | | | | 759 | | | | 1,102 | | | | 789 | | | | 1,007 | | | | 3,657 | |
| Contingent tax liabilities under FIN 48 | | | 11 | | | | 1,473 | | | | | | | | | | | | | | | | 1,473 | |
A schedule of significant commitments at December 31, 2008 follows:
| (In thousands) | | | |
| Commitments to extend credit: | | | |
| Commercial and industrial | | $ | 60,676 | |
| Real estate – mortgage | | | 53 | |
| Real estate – construction | | | 30,502 | |
| Agricultural | | | 16,597 | |
| Installment | | | 3,638 | |
| Revolving home equity and credit card lines | | | 814 | |
| | | | | |
| Standby letters of credit | | | 7,119 | |
Further discussion of these commitments is included in Notes 3 and 14 to the consolidated financial statements.
Regulatory Matters
Capital Adequacy
Capital adequacy for bank holding companies and their subsidiary banks has become increasingly important in recent years. Continued deregulation of the banking industry since the 1980's has resulted in, among other things, a broadening of business activities allowed beyond that of traditional banking products and services. Because of this volatility within the banking and financial services industry, regulatory agencies have increased their focus upon ensuring that banking institutions meet certain capital requirements as a means of protecting depositors and investors against such volatility.
During July 2007, the Company redeemed its $15.0 million in Trust Preferred Securities originally issued during 2001 under United Security Bancshares Capital Trust I. During the same month, the Company issued $15.0 million in new Trust Preferred Securities with similar terms under newly formed United Security Bancshares Capital Trust II. Under applicable regulatory guidelines, the Trust Preferred Securities qualify as Tier 1 capital up to a maximum of 25% of Tier 1 capital. Any additional portion will qualify as Tier 2 capital. As shareholders’ equity increases, the amount of Tier 1 capital that can be comprised of Trust Preferred Securities will increase.
The Board of Governors of the Federal Reserve System (“Board of Governors”) has adopted regulations requiring insured institutions to maintain a minimum leverage ratio of Tier 1 capital (the sum of common stockholders' equity, noncumulative perpetual preferred stock and minority interests in consolidated subsidiaries, minus intangible assets, identified losses and investments in certain subsidiaries, plus unrealized losses or minus unrealized gains on available for sale securities) to total assets. Institutions which have received the highest composite regulatory rating and which are not experiencing or anticipating significant growth are required to maintain a minimum leverage capital ratio of 3% Tier 1 capital to total assets. To be considered well capitalized, the institution must maintain a leverage capital ratio of 5%. All other institutions are required to maintain a minimum leverage capital ratio of at least 100 to 200 basis points above the minimum requirements.
The Board of Governors has also adopted a statement of policy, supplementing its leverage capital ratio requirements, which provides definitions of qualifying total capital (consisting of Tier 1 capital and Tier 2 supplementary capital, including the allowance for loan losses up to a maximum of 1.25% of risk-weighted assets) and sets forth minimum risk-based capital ratios of capital to risk-weighted assets. The most highly rated insured institutions are required to maintain a minimum ratio of qualifying total capital to risk weighted assets of 8%, at least one-half (4%) of which must be in the form of Tier 1 capital. To be considered well capitalized, institutions must maintain a ratio of qualifying total capital to risk weighted assets of 10%, at least one-half (6%) of which must be in the form of Tier 1 capital.
The following table sets forth the Company’s and the Bank's actual capital positions at December 31, 2008 and the regulatory minimums for the Company and the Bank to be well capitalized under the guidelines discussed above:
| | | Company | | | Bank | | | Regulatory | |
| | | Actual | | | Actual | | | Minimums - | |
| | | Capital Ratios | | | Capital Ratios | | | Well Capitalized | |
| Total risk-based capital ratio | | | 13.23 | % | | | 12.61 | % | | | 10.00 | % |
| Tier 1 capital to risk-weighted assets | | | 11.97 | % | | | 11.45 | % | | | 6.00 | % |
| Leverage ratio | | | 10.58 | % | | | 10.45 | % | | | 5.00 | % |
Under Federal Reserve guidelines, the Company and the Bank are required to maintain a total risk-based capital ratio of 10%, tier 1 capital to risk-weighted assets of 8%, and a leverage ratio of 7%, to be considered well capitalized. As is indicated by the above table, the Company and the Bank exceeded all applicable regulatory capital guidelines at December 31, 2008. Management believes that, under the current regulations, both will continue to meet their minimum capital requirements in the foreseeable future.
Dividends
Dividends paid to shareholders by the Company are subject to restrictions set forth in the California General Corporation Law. The California General Corporation Law provides that a corporation may make a distribution to its shareholders if retained earnings immediately prior to the dividend payout are at least equal the amount of the proposed distribution. The primary source of funds with which dividends will be paid to shareholders will come from cash dividends received by the Company from the Bank. During the year ended December 31, 2008, the Company received $4.3 million in cash dividends from the Bank, from which the Company declared $3.1 million in dividends to shareholders.
The Bank as a state-chartered bank is subject to dividend restrictions set forth in California state banking law, and administered by the California Commissioner of Financial Institutions (“Commissioner”). Under such restrictions, the Bank may not pay cash dividends in an amount which exceeds the lesser of the retained earnings of the Bank or the Bank’s net income for the last three fiscal years (less the amount of distributions to shareholders during that period of time). If the above test is not met, cash dividends may only be paid with the prior approval of the Commissioner, in an amount not exceeding the Bank’s net income for its last fiscal year or the amount of its net income for the current fiscal year. Such restrictions do not apply to stock dividends, which generally require neither the satisfaction of any tests nor the approval of the Commissioner. Notwithstanding the foregoing, if the Commissioner finds that the shareholders’ equity is not adequate or that the declarations of a dividend would be unsafe or unsound, the Commissioner may order the state bank not to pay any dividend. The FRB may also limit dividends paid by the Bank. This is not the case with the Bank. Year-to-date dividends of $4.3 million and $4.6 million paid to shareholders and the Company, respectively, through December 31, 2008 were within the maximum allowed under those regulatory guidelines, and did not require prior approval of the Commissioner.
Stock Repurchase Plan (all figures have been restated to reflect effect of 2-for-1 stock split during May 2006)
| | | For the Quarters Ended | | | | |
| | | March 31, | | | June 30, | | | September 30, | | | December 31, | | | YTD | |
| Shares repurchased – 2008 | | | 29,626 | | | | 34,574 | | | | 1,886 | | | | 22,915 | | | | 89,001 | |
| Average price paid – 2008 | | $ | 15.26 | | | $ | 15.2 | | | $ | 15.09 | | | $ | 9.31 | | | $ | 13.70 | |
| | | | | | | | | | | | | | | | | | | | | |
| Shares repurchased – 2007 | | | 117,403 | | | | 306,758 | | | | 28,916 | | | | 59,255 | | | | 512,332 | |
| Average price paid – 2007 | | $ | 21.48 | | | $ | 19.89 | | | $ | 18.32 | | | $ | 18.32 | | | $ | 19.71 | |
| | | | | | | | | | | | | | | | | | | | | |
| Shares repurchased – 2006 | | | 84 | | | | 13,121 | | | | 84,215 | | | | 10,585 | | | | 108,005 | |
| Average price paid - 2006 | | $ | 16.57 | | | $ | 23.13 | | | $ | 22.21 | | | $ | 24.58 | | | $ | 22.55 | |
| | | | | | | | | | | | | | | | | | | | | |
| Shares repurchased - 2005 | | | 7,152 | | | | 4,936 | | | | 0 | | | | 14,074 | | | | 26,162 | |
| Average price paid - 2005 | | $ | 12.28 | | | $ | 12.78 | | | $ | — | | | $ | 16.16 | | | $ | 14.46 | |
| | | | | | | | | | | | | | | | | | | | | |
| Shares repurchased - 2004 | | | 19,800 | | | | 109,490 | | | | 45,986 | | | | 3,564 | | | | 178,840 | |
| Average price paid - 2004 | | $ | 12.85 | | | $ | 11.41 | | | $ | 11.29 | | | $ | 12.11 | | | $ | 11.55 | |
On February 25, 2004 the Company announced a second stock repurchase plan under which the Board of Directors approved a plan to repurchase, as conditions warrant, up to 276,500 shares (553,000 shares adjusted for May 2006 stock split) of the Company's common stock on the open market or in privately negotiated transactions. As with the first stock repurchase plan initiated during 2001, the duration of the new program was open-ended and the timing of purchases will depend on market conditions. Concurrent with the approval of the new repurchase plan, the Board terminated the 2001 repurchase plan and canceled the remaining 64,577 shares (129,154 shares adjusted for May 2006 stock split) yet to be purchased under the earlier plan.
On May 16, 2007, the Company announced another stock repurchase plan to repurchase, as conditions warrant, up to 610,000 shares of the Company's common stock on the open market or in privately negotiated transactions. The repurchase plan represents approximately 5.00% of the Company's currently outstanding common stock. The duration of the program is open-ended and the timing of purchases will depend on market conditions. Concurrent with the approval of the new repurchase plan, the Company canceled the remaining 75,733 shares available under the 2004 repurchase plan.
During the year ended December 31, 2007, 512,332 shares were repurchased at a total cost of $10.1 million and an average per share price of $19.71. Of the shares repurchased during 2007, 166,660 shares were repurchased under the 2004 plan at an average cost of $20.46 per shares, and 345,672 shares were repurchased under the 2007 plan at an average cost of $19.35 per share.
During the year ended December 31, 2008, 89,001 shares were repurchased at a total cost of $1.2 million and an average per share price of $13.70
Reserve Balances
The Bank is required to maintain average reserve balances with the Federal Reserve Bank. During 2005, the Company implemented a deposit reclassification program, which allows the Company to reclassify a portion of transaction accounts to non-transaction accounts for reserve purposes. The deposit reclassification program was provided by a third-party vendor, and has been approved by the Federal Reserve Bank. At December 31, 2008 the Bank's qualifying balance with the Federal Reserve was approximately $25,000.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Interest Rate Sensitivity and Market Risk
An interest rate-sensitive asset or liability is one that, within a defined time period, either matures or is subject to interest rate adjustments as market rates of interest change. Interest rate sensitivity is the measure of the volatility of earnings from movements in market rates of interest, which is generally reflected in interest rate spread. As interest rates change in the market place, yields earned on assets do not necessarily move in tandem with interest rates paid on liabilities. Interest rate sensitivity is related to liquidity in that each is affected by maturing assets and sources of funds. Interest rate sensitivity is also affected by assets and liabilities with interest rates that are subject to change prior to maturity.
The object of interest rate sensitivity management is to minimize the impact on earnings from interest rate changes in the marketplace. In recent years, deregulation, causing liabilities to become more interest rate sensitive, combined with interest rate volatility in the capital markets, has placed additional emphasis on this principal. When management decides to maintain repricing imbalances, it usually does so on the basis of a well- conceived strategy designed to ensure that the risk is not excessive and that liquidity is properly maintained. The Company's interest rate risk management is the responsibility of the Asset/Liability Management Committee (ALCO), which reports to the Board of Directors on a periodic basis, pursuant to established operating policies and procedures.
As part of its overall risk management, the Company pursues various asset and liability management strategies, which may include obtaining derivative financial instruments to mitigate the impact of interest fluctuations on the Company’s net interest margin. During the second quarter of 2003, the Company entered into a five-year amortizing interest rate swap agreement with the purpose of minimizing interest rate fluctuations on its interest rate margin and equity. The interest rate swap agreement matured on September 30, 2008.
Under the interest rate swap agreement, the Company received a fixed rate and pays a variable rate based on the Prime Rate (“Prime”). The swap qualified as a cash flow hedge under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended, and was designated as a hedge of the variability of cash flows the Company receives from certain variable-rate loans indexed to Prime. In accordance with SFAS No. 133, the swap agreement was measured at fair value and reported as an asset or liability on the consolidated balance sheet. The portion of the change in the fair value of the swap that was deemed effective in hedging the cash flows of the designated assets were recorded in accumulated other comprehensive income and reclassified into interest income when such cash flow actually occured. Any ineffectiveness resulting from the hedge was recorded as a gain or loss in the consolidated statement of income as part of noninterest income. The amortizing hedge had a remaining notional value of $1.8 million and duration of approximately three months at December 31, 2007, and matured on September 30, 2008. During the years ended December 31, 2008 and 2007, $5,000 and $310,000, respectively, was reclassified from accumulated other comprehensive income as a reduction to interest income.
The Company performed a quarterly analysis of the effectiveness of the interest rate swap agreement at December 31, 2007 and for each of the quarters ended March 31, 2008 and June 30, 2008. As a result of a correlation analysis, the Company determined that the swap remained highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge and, therefore, continued to qualify for hedge accounting under the guidelines of SFAS No. 133. However, during the second quarter of 2006, the Company determined that the underlying loans being hedged were paying off faster than the notional value of the hedge instrument was amortizing. This difference between the notional value of the hedge and the underlying hedged assets is considered an “overhedge” pursuant to SFAS No. 133 guidelines and may constitute ineffectiveness if the difference is other than temporary. The Company determined during 2006 that the difference was other than temporary and, as a result, reclassified a net total of $75,000 of the pretax hedge loss reported in other comprehensive income into earnings during 2006. As of December 31, 2007, the notional value of the hedge was still in excess of the value of the underlying loans being hedged by approximately $1.3 million, but had improved from the $3.3 million difference existing at December 31, 2006. As a result, the Company recorded a pretax hedge gain related to swap ineffectiveness of approximately $66,000 during the December 31, 2007. With the interest rate swap maturing on September 30, 2008, the Company recognized the remaining hedge ineffectiveness gains of $9,000 during 2008. Amounts recognized as hedge ineffectiveness gains or losses are reflected in noninterest income.
Interest rate risk can be measured through various methods including gap, duration and market value analysis as well as income simulation models, which provides a dynamic view of interest rate sensitivity based on the assumptions of the Company’s Management. The Company employs each of these methods and refines these processes to make the most accurate measurements possible. The information provided by these calculations is the basis for management decisions in managing interest rate risk.
From the “Gap” report below, the Company is apparently subject to interest rate risk to the extent that its liabilities have the potential to reprice more quickly than its assets within the next year. At December 31, 2008, the Company had a cumulative 12-month Gap of $20.7 million or 3.4% of total earning assets. Management believes the Gap analysis shown below is not entirely indicative of the Company’s actual interest rate sensitivity, because certain interest-sensitive liabilities would not reprice to the same degree as interest-sensitive assets. For example, if the prime rate were to change by 50 basis points, the floating rate loans included in the $265.0 million immediately adjustable category would change by the full 50 basis points. Interest bearing checking and savings accounts which are also included in the immediately adjustable column probably would move only a portion of the 50 basis point rate change and, in fact, might not even move at all. The effects of market value risk have been mitigated to some degree by the makeup of the Bank's balance sheet. Loans are generally short-term or are floating-rate instruments. At December 31, 2008, $457.8 million or 91.8% of the loan portfolio matures or reprices within one year, and less than 1.0% of the portfolio matures or reprices in more than 5 years.
Total investment securities including call options and prepayment assumptions, have a combined duration of approximately 1.7 years. More than $505.4 million or 96.1% of interest-bearing liabilities mature or can be repriced within the next 12 months, even though the rate elasticity of deposits with no defined maturities may not necessarily be the same as interest-earning assets.
The following table sets forth the Company's gap, or estimated interest rate sensitivity profile based on ending balances as of December 31, 2008, representing the interval of time before earning assets and interest-bearing liabilities may respond to changes in market rates of interest. Assets and liabilities are categorized by remaining interest rate maturities rather than by principal maturities of obligations.
Maturities and Interest Rate Sensitivity
| | | December 31, 2008 | |
| | | | | | | | | After Three | | | After One | | | | | | | |
| | | | | | Next Day But | | | Months | | | Year But | | | After | | | | |
| | | | | | Within Three | | | Within 12 | | | Within Five | | | Five | | | | |
| (In thousands) | | Immediately | | | Months | | | Months | | | Years | | | Years | | | Total | |
| Interest Rate Sensitivity Gap: | | | | | | | | | | | | | | | | | | |
| Loans (1) | | $ | 264,978 | | | $ | 116,868 | | | $ | 75,909 | | | $ | 39,193 | | | $ | 1,932 | | | $ | 498,880 | |
| Investment securities | | | | | | | 25,131 | | | | 23,413 | | | | 37,947 | | | | 6,258 | | | | 92,749 | |
| Interest bearing deposits in other banks | | | | | | | 16,500 | | | | 3,336 | | | | 595 | | | | 0 | | | | 20,431 | |
| Federal funds sold and reverse repos | | | | | | | | | | | | | | | | | | | | | | | 0 | |
| Total earning assets | | $ | 264,978 | | | $ | 158,499 | | | $ | 102,658 | | | $ | 77,735 | | | $ | 8,190 | | | $ | 612,060 | |
| Interest-bearing | | | | | | | | | | | | | | | | | | | | | | | | |
| transaction accounts | | | 136,612 | | | | | | | | | | | | | | | | | | | | 136,612 | |
| Savings accounts | | | 37,586 | | | | | | | | | | | | | | | | | | | | 37,586 | |
| Time deposits (2) | | | 7,381 | | | | 80,106 | | | | 87,778 | | | | 9,483 | | | | 11 | | | | 184,759 | |
| Federal funds purchased/other borrowings | | | 66,545 | | | | 77,500 | | | | | | | | 11,000 | | | | | | | | 155,045 | |
| Junior subordinated debt | | | | | | | 11,926 | | | | | | | | | | | | | | | | 11,926 | |
| Total interest-bearing liabilities | | $ | 248,124 | | | $ | 169,532 | | | $ | 87,778 | | | $ | 20,483 | | | $ | 11 | | | $ | 525,928 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Interest rate sensitivity gap | | $ | 16,854 | | | $ | (11,033 | ) | | $ | 14,880 | | | $ | 57,252 | | | $ | 8,179 | | | $ | 86,132 | |
| Cumulative gap | | $ | 16,854 | | | $ | 5,821 | | | $ | 20,701 | | | $ | 77,963 | | | $ | 86,132 | | | | | |
| Cumulative gap percentage to | | | | | | | | | | | | | | | | | | | | | | | | |
| Total earning assets | | | 2.8 | % | | | 1.0 | % | | | 3.4 | % | | | 12.7 | % | | | 14.1 | % | | | | |
(1) Loan balance does not include nonaccrual loans of $51.906 million.
(2) See above for discussion of the impact of floating rate CD’s.
The Company utilizes a vendor-purchased simulation model to analyze net interest income sensitivity to movements in interest rates. The simulation model projects net interest income based on a 100, 200, and 300 basis point rise and a 100, 200, and 300 basis point fall in interest rates ramped over a twelve-month period, with net interest impacts projected out as far as twenty-four months. In addition, a “most likely” scenario is projected based upon expected rate changes over the 24-month period. The model is based on the actual maturity and repricing characteristics of the Company's interest-sensitive assets and liabilities. The model incorporates assumptions regarding the impact of changing interest rates on the prepayment of certain assets and liabilities. Projected net interest income is calculated assuming customers will reinvest maturing deposit accounts and the Company will originate new loans. The balance sheet growth assumptions utilized correspond closely to the Company's strategic growth plans and annual budget. Excess cash is invested in overnight funds or other short-term investments such as U.S. Treasuries. Cash shortfalls are covered through additional borrowing of overnight or short-term funds. The Board of Directors has adopted an interest rate risk policy which establishes maximum decreases in net interest income of 12% and 15% in the event of a 100 BP and 200 BP increase or decrease in market interest rates over a twelve month period. Based on the information and assumptions utilized in the simulation model at December 31, 2008, the resultant projected impact on net interest income falls within policy limits set by the Board of Directors for all rate scenarios simulated.
The Company also utilizes the same vendor-purchased simulation model to project the impact of changes in interest rates on the underlying market value of all the Company's assets, liabilities, and off-balance sheet accounts under alternative interest rate scenarios. The resultant net value, as impacted under each projected interest rate scenario, is referred to as the market value of equity ("MV of Equity"). This technique captures the interest rate risk of the Company's business mix across all maturities. The market analysis is performed using an immediate rate shock of 100, 200, and 300 basis points up and down calculating the present value of expected cash flows under each rate environment at applicable discount rates. The market value of loans is calculated by discounting the expected future cash flows over either the term to maturity for fixed rate loans or scheduled repricing for floating rate loans using the current rate at which similar loans would be made to borrowers with similar credit ratings. The market value of investment securities is based on quoted market prices obtained from reliable independent brokers. The market value of time deposits is calculated by discounting the expected cash flows using current rates for similar instruments of comparable maturities. The market value of deposits with no defined maturities, including interest-bearing checking, money market and savings accounts is calculated by discounting the expected cash flows at a rate equal to the difference between the cost of these deposits and the alternate use of the funds, federal funds in this case. Assumed maturities for these deposits are estimated using decay analysis and are generally assumed to have implied maturities of less than five years. For noninterest sensitive assets and liabilities, the market value is equal to their carrying value amounts at the reporting date. The Company's interest rate risk policy establishes maximum decreases in the Company's market value of equity of 12% and 15% in the event of an immediate and sustained 100 BP and 200 BP increase or decrease in market interest rates. As shown in the table below, the percentage changes in the net market value of the Company's equity are within policy limits for both rising and falling rate scenarios.
The following sets forth the analysis of the Company's market value risk inherent in its interest-sensitive financial instruments as they relate to the entire balance sheet at December 31, 2008 and December 31, 2007 ($ in thousands). Fair value estimates are subjective in nature and involve uncertainties and significant judgment and, therefore, cannot be determined with absolute precision. Assumptions have been made as to the appropriate discount rates, prepayment speeds, expected cash flows and other variables. Changes in these assumptions significantly affect the estimates and as such, the obtained fair value may not be indicative of the value negotiated in the actual sale or liquidation of such financial instruments, nor comparable to that reported by other financial institutions. In addition, fair value estimates are based on existing financial instruments without attempting to estimate future business.
| | | December 31, 2008 | | | December 31, 2007 | |
| Change in | | Estimated MV | | | Change in MV | | | Change in MV | | | Estimated MV | | | Change in MV | | | Change in MV | |
| Rates | | of Equity | | | Of Equity $ | | | Of Equity % | | | of Equity | | | of Equity $ | | | Of Equity % | |
| + 200 BP | | $ | 78,206 | | | $ | 2,935 | | | | 3.90 | % | | $ | 105,596 | | | $ | 3,028 | | | | 2.95 | % |
| + 100 BP | | | 77,483 | | | | 2,212 | | | | 2.94 | % | | | 105,207 | | | | 2,639 | | | | 2.57 | % |
| 0 BP | | | 75,270 | | | | 0 | | | | 0.00 | % | | | 102,568 | | | | 0 | | | | 0.00 | % |
| - 100 BP | | | 76,528 | | | | 1,258 | | | | 1.67 | % | | | 97,410 | | | | (5,158 | ) | | | -5.03 | % |
| - 200 BP | | | 78,732 | | | | 3,462 | | | | 4.60 | % | | | 91,212 | | | | (11,356 | ) | | | -11.07 | % |
Index to Consolidated Financial Statements:
| Reports of Independent Registered Public Accounting Firm | |
| | |
| Consolidated Balance Sheets - December 31, 2008 and 2007 | |
| | |
| Consolidated Statements of Income and Comprehensive Income - | |
| Years Ended December 31, 2008, 2007 and 2006 | |
| | |
| Consolidated Statements of Shareholders' Equity - | |
| Years Ended December 31, 2008, 2007 and 2006 | |
| | |
| Consolidated Statements of Cash Flows - | |
| Years Ended December 31, 2008, 2007 and 2006 | |
| | |
| Notes to Consolidated Financial Statements | |
Moss Adams LLP
Certified Public Accountants
Report of Independent Registered Public Accounting Firm
To the Board of Directors
United Security Bancshares
We have audited the accompanying consolidated balance sheets of United Security Bancshares and Subsidiaries (Company) as of December 31, 2008 and 2007, and the related consolidated statements of income and comprehensive income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 2008. These consolidated financial statements are the responsibility of Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and 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 consolidated financial position of United Security Bancshares and Subsidiaries as of December 31, 2008 and 2007, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2008, in conformity with U.S. generally accepted accounting principles in the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 16 2009 expressed an unqualified opinion thereon.
As discussed in Note 9 and 15 to the consolidated financial statements, effective January 1, 2007, the Company adopted the provisions of SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, and SFAS No. 157, Fair Value Measurements. As discussed in Note 11 to the consolidated financial statements, effective January 1, 2007, the Company adopted the provisions of FIN 48, Accounting for uncertainty in Income Taxes.
/s/ Moss Adams LLP
Stockton, California
March 16, 2009
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of
United Security Bancshares and Subsidiaries
We have audited United Security Bancshares and Subsidiaries (the Company) internal control over financial reporting as of December 31, 2008, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also includes performing such other procedures, as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States of America. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, United Security Bancshares and Subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of United Security Bancshares and Subsidiaries as of December 31, 2008 and 2007, and the related consolidated statements of income and comprehensive income, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2008, and our report dated March 16, 2009 expressed an unqualified opinion thereon.
/s/ Moss Adams LLP
Stockton, California
March 16, 2009
United Security Bancshares and Subsidiaries
Consolidated Balance Sheets
December 31, 2008 and 2007
| | | December 31, | |
| (in thousands except shares) | | 2008 | | | 2007 | |
| Assets | | | | | | |
| Cash and due from banks | | $ | 19,426 | | | $ | 25,300 | |
| Federal funds sold | | | 0 | | | | 0 | |
| Cash and cash equivalents | | | 19,426 | | | | 25,300 | |
| Interest-bearing deposits in other banks | | | 20,431 | | | | 2,909 | |
| Investment securities available for sale (at fair value) | | | 92,749 | | | | 89,415 | |
| Loans and leases | | | 549,976 | | | | 598,220 | |
| Unearned fees | | | (1,234 | ) | | | (1,739 | ) |
| Allowance for credit losses | | | (15,071 | ) | | | (10,901 | ) |
| Net loans | | | 533,671 | | | | 585,580 | |
| Accrued interest receivable | | | 2,394 | | | | 3,658 | |
| Premises and equipment - net | | | 14,285 | | | | 15,574 | |
| Other real estate owned | | | 30,153 | | | | 6,666 | |
| Intangible assets | | | 3,001 | | | | 4,621 | |
| Goodwill | | | 10,417 | | | | 10,417 | |
| Cash surrender value of life insurance | | | 14,460 | | | | 13,852 | |
| Investment in limited partnerships | | | 2,702 | | | | 3,134 | |
| Deferred income taxes | | | 7,138 | | | | 4,301 | |
| Other assets | | | 10,250 | | | | 6,288 | |
| Total assets | | $ | 761,077 | | | $ | 771,715 | |
| | | | | | | | | |
| Liabilities & Shareholders' Equity | | | | | | | | |
| Liabilities | | | | | | | | |
| Deposits | | | | | | | | |
| Noninterest bearing | | $ | 149,529 | | | $ | 139,066 | |
| Interest bearing | | | 358,957 | | | | 495,551 | |
| Total deposits | | | 508,486 | | | | 634,617 | |
| | | | | | | | | |
| Federal funds purchased | | | 66,545 | | | | 10,380 | |
| Other borrowings | | | 88,500 | | | | 21,900 | |
| Accrued interest payable | | | 648 | | | | 1,903 | |
| Accounts payable and other liabilities | | | 5,362 | | | | 7,143 | |
| Junior subordinated debt (at fair value) | | | 11,926 | | | | 13,341 | |
| Total liabilities | | | 681,467 | | | | 689,284 | |
| Commitments and Contingent Liabilities | | | — | | | | — | |
| Shareholders' Equity | | | | | | | | |
| Common stock, no par value | | | | | | | | |
| 20,000,000 shares authorized, 12,010,372 and 11,855,192 | | | | | | | | |
| issued and outstanding, in 2008 and 2007, respectively | | | 34,811 | | | | 32,587 | |
| Retained earnings | | | 47,722 | | | | 49,997 | |
| Accumulated other comprehensive loss | | | (2,923 | ) | | | (153 | ) |
| Total shareholders' equity | | | 79,610 | | | | 82,431 | |
| Total liabilities and shareholders' equity | | $ | 761,077 | | | $ | 771,715 | |
| | | | | | | | | |
See notes to consolidated financial statements
United Security Bancshares and Subsidiaries
Consolidated Statements of Income and Comprehensive Income
Years Ended December 31, 2008, 2007 and 2006
| (in thousands except shares and EPS) | | 2008 | | | 2007 | | | 2006 | |
| Interest Income | | | | | | | | | |
| Loans, including fees | | $ | 39,669 | | | $ | 52,690 | | | $ | 42,902 | |
| Investment securities - AFS – taxable | | | 5,170 | | | | 3,896 | | | | 3,254 | |
| Investment securities - AFS – nontaxable | | | 68 | | | | 108 | | | | 108 | |
| Federal funds sold and securities purchased | | | | | | | | | | | | |
| under agreements to resell | | | 18 | | | | 191 | | | | 768 | |
| Interest on deposits in other banks | | | 222 | | | | 271 | | | | 324 | |
| Total interest income | | | 45,147 | | | | 57,156 | | | | 47,356 | |
| Interest Expense | | | | | | | | | | | | |
| Interest on deposits | | | 12,088 | | | | 18,414 | | | | 12,597 | |
| Interest on other borrowed funds | | | 2,850 | | | | 2,159 | | | | 1,578 | |
| Total interest expense | | | 14,938 | | | | 20,573 | | | | 14,175 | |
| Net Interest Income Before | | | | | | | | | | | | |
| Provision for Credit Losses | | | 30,209 | | | | 36,583 | | | | 33,181 | |
| Provision for Credit Losses | | | 9,598 | | | | 5,697 | | | | 880 | |
| Net Interest Income | | | 20,611 | | | | 30,886 | | | | 32,301 | |
| Noninterest Income | | | | | | | | | | | | |
| Customer service fees | | | 4,656 | | | | 4,790 | | | | 3,779 | |
| Gain on disposition of securities | | | 24 | | | | 0 | | | | 27 | |
| Gain on sale of other real estate owned | | | 67 | | | | 209 | | | | 50 | |
| Gains from life insurance | | | 0 | | | | 483 | | | | 482 | |
| Gain (loss) on interest swap ineffectiveness | | | 9 | | | | 66 | | | | (75 | ) |
| Gain on sale of investment | | | 0 | | | | 0 | | | | 1,877 | |
| Gain on fair value option of financial liability | | | 1,363 | | | | 2,504 | | | | 0 | |
| (Loss) gain on sale of premises and equipment | | | (4 | ) | | | 2 | | | | 1,018 | |
| Shared appreciation income | | | 265 | | | | 42 | | | | 567 | |
| Other | | | 1,963 | | | | 1,568 | | | | 1,306 | |
| Total noninterest income | | | 8,343 | | | | 9,664 | | | | 9,031 | |
| Noninterest Expense | | | | | | | | | | | | |
| Salaries and employee benefits | | | 10,610 | | | | 10,830 | | | | 9,915 | |
| Occupancy expense | | | 3,954 | | | | 3,787 | | | | 2,556 | |
| Data processing | | | 279 | | | | 420 | | | | 470 | |
| Professional fees | | | 1,482 | | | | 1,811 | | | | 998 | |
| Director fees | | | 262 | | | | 268 | | | | 222 | |
| Amortization of intangibles | | | 972 | | | | 1,021 | | | | 537 | |
| Correspondent bank service charges | | | 427 | | | | 476 | | | | 204 | |
| Impairment loss on other investments | | | 23 | | | | 17 | | | | 0 | |
| Impairment loss on OREO | | | 887 | | | | 0 | | | | 0 | |
| Impairment loss on intangible assets | | | 648 | | | | 0 | | | | 0 | |
| Loss on lease assets held for sale | | | 0 | | | | 820 | | | | 0 | |
| Loss in equity of limited partnership | | | 432 | | | | 430 | | | | 440 | |
| Expense on other real estate owned | | | 418 | | | | 209 | | | | 2,193 | |
| Other | | | 2,885 | | | | 2,643 | | | | 2,402 | |
| Total noninterest expense | | | 23,279 | | | | 22,732 | | | | 19,937 | |
| Income Before Provision for Taxes on Income | | | 5,675 | | | | 17,818 | | | | 21,395 | |
| Provision for Taxes on Income | | | 1,605 | | | | 6,561 | | | | 8,035 | |
| Net Income | | $ | 4,070 | | | $ | 11,257 | | | $ | 13,360 | |
| Other comprehensive income, net of tax | | | | | | | | | | | | |
| Unrealized income (loss) on available for sale securities, interest rate | | | | | | | | | | | | |
| swaps, and unrecognized post-retirement costs - net income | | | | | | | | | | | | |
| tax (benefit) expense of $(1,845), $758, and $381, respectively | | | (2,770 | ) | | | 1,137 | | | | 631 | |
| Comprehensive Income | | $ | 1,300 | | | $ | 12,394 | | | $ | 13,991 | |
| Net Income per common share | | | | | | | | | | | | |
| Basic | | $ | 0.34 | | | $ | 0.93 | | | $ | 1.15 | |
| Diluted | | $ | 0.34 | | | $ | 0.92 | | | $ | 1.14 | |
| Weighted shares on which net income per common share | | | | | | | | | | | | |
| were based | | | | | | | | | | | | |
| Basic | | | 12,048,728 | | | | 12,165,475 | | | | 11,572,407 | |
| Diluted | | | 12,052,150 | | | | 12,200,920 | | | | 11,692,705 | |
See notes to consolidated financial statements
United Security Bancshares and Subsidiaries
Consolidated Statements of Changes in Shareholders' Equity
Years Ended December 31, 2008
| | | | | | | | | | | | Accumulated | | | | |
| | | Common stock | | | | | | | | | Other | | | | |
| | | Number | | | | | | Retained | | | Comprehensive | | | | |
| (in thousands except shares) | | of Shares | | | Amount | | | Earnings | | | Income (Loss) | | | Total | |
| | | | | | | | | | | | | | | | |
| Balance January 1, 2006 | | | 11,361,118 | | | $ | 22,084 | | | $ | 38,682 | | | $ | (1,752 | ) | | $ | 59,014 | |
| | | | | | | | | | | | | | | | | | | | | |
| Director/Employee stock options exercised | | | 48,000 | | | | 335 | | | | | | | | | | | | 335 | |
| Tax benefit of stock options exercised | | | | | | | 218 | | | | | | | | | | | | 218 | |
| Net changes in unrealized gain | | | | | | | | | | | | | | | | | | | | |
| on available for sale securities | | | | | | | | | | | | | | | | | | | | |
| (net of income tax expense of $242 ) | | | | | | | | | | | | | | | 363 | | | | 363 | |
| Net changes in unrealized gain | | | | | | | | | | | | | | | | | | | | |
| on interest rate swaps | | | | | | | | | | | | | | | | | | | | |
| (net of income tax expense of $140) | | | | | | | | | | | | | | | 268 | | | | 268 | |
| Adjustment to initially apply SFAS No. 158 | | | | | | | | | | | | | | | | | | | | |
| (net of income tax benefit of $112) | | | | | | | | | | | | | | | (169 | ) | | | (169 | ) |
| Dividends on common stock ($0.445 per share) | | | | | | | | | | | (5,158 | ) | | | | | | | (5,158 | ) |
| Repurchase and retirement of common shares | | | (108,005 | ) | | | (2,437 | ) | | | | | | | | | | | (2,437 | ) |
| Stock-based compensation expense | | | | | | | 248 | | | | | | | | | | | | 248 | |
| Net Income | | | | | | | | | | | 13,360 | | | | | | | | 13,360 | |
| | | | | | | | | | | | | | | | | | | | | |
| Balance December 31, 2006 | | | 11,301,113 | | | | 20,448 | | | | 46,884 | | | | (1,290 | ) | | | 66,042 | |
| | | | | | | | | | | | | | | | | | | | | |
| Director/Employee stock options exercised | | | 90,000 | | | | 510 | | | | | | | | | | | | 510 | |
| Net changes in unrealized gain | | | | | | | | | | | | | | | | | | | | |
| on available for sale securities | | | | | | | | | | | | | | | | | | | | |
| (net of income tax expense of $605) | | | | | | | | | | | | | | | 909 | | | | 909 | |
| Net changes in unrealized gain | | | | | | | | | | | | | | | | | | | | |
| on interest rate swaps | | | | | | | | | | | | | | | | | | | | |
| (net of income tax expense of $97) | | | | | | | | | | | | | | | 145 | | | | 145 | |
| Net changes in unrecognized past service | | | | | | | | | | | | | | | | | | | | |
| Costs of employee benefit plans | | | | | | | | | | | | | | | | | | | | |
| (net of income tax expense of $55) | | | | | | | | | | | | | | | 83 | | | | 83 | |
| Dividends on common stock ($0.50 per share) | | | | | | | | | | | (6,001 | ) | | | | | | | (6,001 | ) |
| Repurchase and retirement of common shares | | | (512,332 | ) | | | (10,094 | ) | | | | | | | | | | | (10,094 | ) |
| Issuance of shares for business combination | | | 976,411 | | | | 21,536 | | | | | | | | | | | | 21,536 | |
| Stock-based compensation expense | | | | | | | 187 | | | | | | | | | | | | 187 | |
| Cumulative effect of adoption of SFAS No. 159 | | | | | | | | | | | | | | | | | | | | |
| (net income tax benefit of $613) | | | | | | | | | | | (845 | ) | | | | | | | (845 | ) |
| Cumulative effect of adoption of FIN48 | | | | | | | | | | | (1,298 | ) | | | | | | | (1,298 | ) |
| Net Income | | | | | | | | | | | 11,257 | | | | | | | | 11,257 | |
| | | | | | | | | | | | | | | | | | | | | |
| Balance December 31, 2007 | | | 11,855,192 | | | $ | 32,587 | | | $ | 49,997 | | | $ | (153 | ) | | $ | 82,431 | |
| | | | | | | | | | | | | | | | | | | | | |
| Director/Employee stock options exercised | | | 8,000 | | | | 70 | | | | | | | | | | | | 70 | |
| Net changes in unrealized gain | | | | | | | | | | | | | | | | | | | | |
| on available for sale securities | | | | | | | | | | | | | | | | | | | | |
| (net of income tax benefit of $1,910) | | | | | | | | | | | | | | | (2,865 | ) | | | (2,865 | ) |
| Net changes in unrealized gain | | | | | | | | | | | | | | | | | | | | |
| on interest rate swaps | | | | | | | | | | | | | | | | | | | | |
| (net of income tax expense of $1) | | | | | | | | | | | | | | | 2 | | | | 2 | |
| Net changes in unrecognized past service | | | | | | | | | | | | | | | | | | | | |
| Costs of employee benefit plans | | | | | | | | | | | | | | | | | | | | |
| (net of income tax expense of $62) | | | | | | | | | | | | | | | 93 | | | | 93 | |
| Dividends on common stock ($0.26 per share) | | | | | | | | | | | (3,081 | ) | | | | | | | (3,081 | ) |
| Common stock dividends | | | 236,181 | | | | 3,264 | | | | (3,264 | ) | | | | | | | 0 | |
| Repurchase and retirement of common shares | | | (89,001 | ) | | | (1,220 | ) | | | | | | | | | | | (1,220 | ) |
| Stock-based compensation expense | | | | | | | 110 | | | | | | | | | | | | 110 | |
| Net Income | | | | | | | | | | | 4,070 | | | | | | | | 4,070 | |
| | | | | | | | | | | | | | | | | | | | | |
| Balance December 31, 2008 | | | 12,010,372 | | | $ | 34,811 | | | $ | 47,722 | | | $ | (2,923 | ) | | $ | 79,610 | |
See notes to consolidated financial statements
United Security Bancshares and Subsidiaries
Consolidated Statements of Cash Flows
Years December 31, 2008, 2007 and 2006
| (in thousands) | | 2008 | | | 2007 | | | 2006 | |
| Cash Flows From Operating Activities: | | | | | | | | | |
| Net income | | $ | 4,070 | | | $ | 11,257 | | | $ | 13,360 | |
| Adjustments to reconcile net income to cash provided | | | | | | | | | | | | |
| by operating activities: | | | | | | | | | | | | |
| Provision for credit losses | | | 9,598 | | | | 5,697 | | | | 880 | |
| Depreciation and amortization | | | 2,751 | | | | 2,655 | | | | 1,658 | |
| Accretion of investment securities | | | (123 | ) | | | (95 | ) | | | (70 | ) |
| Gain on disposition of securities | | | (24 | ) | | | 0 | | | | (27 | ) |
| Gain on sale of stock | | | 0 | | | | 0 | | | | (1,877 | ) |
| Decrease (increase) in accrued interest receivable | | | 1,263 | | | | 930 | | | | (843 | ) |
| (Decrease) increase in accrued interest payable | | | (1,255 | ) | | | (339 | ) | | | 602 | |
| (Decrease) increase in unearned fees | | | (506 | ) | | | 509 | | | | 246 | |
| Increase (decrease) in income taxes payable | | | 413 | | | | 150 | | | | (245 | ) |
| Excess tax benefits from stock-based payment arrangements | | | 0 | | | | 0 | | | | (1 | ) |
| Stock-based compensation expense | | | 110 | | | | 187 | | | | 248 | |
| Deferred income taxes | | | (1,028 | ) | | | 248 | | | | (382 | ) |
| (Increase) decrease in accounts payable and accrued liabilities | | | (427 | ) | | | (130 | ) | | | 1,290 | |
| Impairment loss on other investments | | | 23 | | | | 17 | | | | 0 | |
| Loss on lease assets held for sale | | | 0 | | | | 820 | | | | 0 | |
| Gain on sale of other real estate owned | | | (67 | ) | | | (209 | ) | | | (50 | ) |
| Impairment loss on other real estate owned | | | 887 | | | | 0 | | | | 0 | |
| Impairment loss on intangible assets | | | 648 | | | | 0 | | | | 0 | |
| (Gain) loss on swap ineffectiveness | | | (9 | ) | | | (66 | ) | | | 75 | |
| Gain on fair value option of financial assets | | | (1,363 | ) | | | (2,504 | ) | | | 0 | |
| Income from life insurance proceeds | | | 0 | | | | (483 | ) | | | (482 | ) |
| Loss (gain) loss on sale of premises and equipment | | | 4 | | | | (2 | ) | | | (1,018 | ) |
| (Increase) decrease in surrender value of life insurance | | | (608 | ) | | | (184 | ) | | | 88 | |
| Loss in limited partnership interest | | | 432 | | | | 430 | | | | 440 | |
| Net (increase) decrease in other assets | | | (2,204 | ) | | | 84 | | | | 2,268 | |
| Net cash provided by operating activities | | | 12,585 | | | | 18,972 | | | | 16,160 | |
| Cash Flows From Investing Activities: | | | | | | | | | | | | |
| Net (increase) decrease in interest-bearing deposits with banks | | | (17,522 | ) | | | 4,984 | | | | (237 | ) |
| Purchases of available-for-sale securities | | | (44,526 | ) | | | (33,859 | ) | | | 0 | |
| Net (purchase) redemption of FHLB/FRB and other bank stock | | | (2,118 | ) | | | 103 | | | | 51 | |
| Maturities, calls, and principal payments on available-for-sale securities | | | 36,887 | | | | 36,833 | | | | 12,571 | |
| Investment in limited partnership | | | 38 | | | | 0 | | | | 0 | |
| Investment in bank stock | | | (72 | ) | | | (372 | ) | | | 0 | |
| Proceeds from sale of investment in title company | | | 0 | | | | 0 | | | | 149 | |
| Premiums paid on life insurance | | | 0 | | | | 0 | | | | (227 | ) |
| Net decrease (increase) in loans | | | 16,526 | | | | (43,454 | ) | | | (84,795 | ) |
| Cash and equivalents received in bank acquisitions, | | | | | | | | | | | | |
| net of assets and liabilities acquired | | | 0 | | | | 6,373 | | | | 0 | |
| Cash proceeds from sale of correspondent bank stock | | | 0 | | | | 0 | | | | 2,607 | |
| Cash proceeds from sales of foreclosed leased assets | | | 56 | | | | 39 | | | | 1,946 | |
| Cash proceeds from sales of other real estate owned | | | 1,710 | | | | 72 | | | | 2,487 | |
| Capital expenditures for premises and equipment | | | (363 | ) | | | (1,200 | ) | | | (5,880 | ) |
| Cash proceeds from sales of premises and equipment | | | 0 | | | | 9 | | | | 1,520 | |
| Net cash used in investing activities | | | (9,384 | ) | | | (30,472 | ) | | | (69,808 | ) |
| Cash Flows From Financing Activities: | | | | | | | | | | | | |
| Net (decrease) increase in demand deposit | | | | | | | | | | | | |
| and savings accounts | | | (9,068 | ) | | | (99,787 | ) | | | 12,764 | |
| Net (decrease) increase in certificates of deposit | | | (117,063 | ) | | | 77,677 | | | | 27,903 | |
| Net increase in federal funds purchased | | | 56,165 | | | | 22,280 | | | | 0 | |
| Net increase in FHLB borrowings | | | 66,600 | | | | 10,000 | | | | 0 | |
| Redemption of junior subordinated debt | | | 0 | | | | (15,923 | ) | | | 0 | |
| Proceeds from issuance of junior subordinated debt | | | 0 | | | | 15,000 | | | | 0 | |
| Director/Employee stock options exercised | | | 70 | | | | 510 | | | | 335 | |
| Excess tax benefits from stock-based payment arrangements | | | 0 | | | | 0 | | | | 1 | |
| Repurchase and retirement of common stock | | | (1,220 | ) | | | (10,095 | ) | | | (2,436 | ) |
| Repayment of ESOP borrowings | | | 0 | | | | 0 | | | | 0 | |
| Payment of dividends on common stock | | | (4,559 | ) | | | (5,930 | ) | | | (4,881 | ) |
| Net cash (used in) provided by financing activities | | | (9,075 | ) | | | (6,268 | ) | | | 33,686 | |
| | | | | | | | | | | | | |
| Net decrease in cash and cash equivalents | | | (5,874 | ) | | | (17,768 | ) | | | (19,962 | ) |
| | | | | | | | | | | | | |
| Cash and cash equivalents at beginning of year | | | 25,300 | | | | 43,068 | | | | 63,030 | |
| | | | | | | | | | | | | |
| Cash and cash equivalents at end of year | | $ | 19,426 | | | $ | 25,300 | | | $ | 43,068 | |
See notes to consolidated statements
Notes to Consolidated Financial Statements
Years Ended December 31, 2008, 2007, and 2006
| 1. | Organization and Summary of Significant Accounting and Reporting Policies |
Basis of Presentation – The consolidated financial statements include the accounts of United Security Bancshares, and its wholly owned subsidiary, United Security Bank and subsidiary (the “Bank”).United Security Bancshares Capital Trust II (the “Trust”) is deconsolidated pursuant to FIN46. As a result, the Trust’s Trust Preferred Securities are not presented on the Company’s consolidated financial statements, but instead the Company’s Subordinated Debentures are presented as a separate liability category. (see Note 10 to the Company’s consolidated financial statements). Intercompany accounts and transactions have been eliminated in consolidation. In the following notes, references to the Bank are references to United Security Bank. References to the Company are references to United Security Bancshares, (including the Bank and Trust). United Security Bancshares operates as one business segment providing banking services to commercial establishments and individuals primarily in the San Joaquin Valley of California.
Nature of Operations – United Security Bancshares is a bank holding company, incorporated in the state of California for the purpose of acquiring all the capital stock of the Bank through a holding company reorganization (the “Reorganization”) of the Bank. The Reorganization, which was accounted for in a manner similar to a pooling of interests, was completed on June 12, 2001. Management believes the Reorganization has provided the Company greater operating and financial flexibility and has permitted expansion into a broader range of financial services and other business activities.
United Security Bancshares Capital Trust I was formed during June 2001 as a Delaware statutory business trust for the exclusive purpose of issuing and selling Trust Preferred Securities. The Trust was deconsolidated in 2004 pursuant to FIN46. During July 2007, the Trust Preferred Securities were redeemed by USB Capital Trust I, and upon retirement, the Trust was dissolved. During July 2007 the Company formed United Security Bancshares Capital Trust II and issued $15.0 million in Trust Preferred Securities with terms similar to those originally issued under USB Capital Trust I. (See Note 10. “Junior Subordinated Debt/Trust Preferred Securities”).
USB Investment Trust Inc was incorporated effective December 31, 2001 as a special purpose real estate investment trust (“REIT”) under Maryland law. The REIT is a subsidiary of the Bank and was funded with $133.0 million in real estate-secured loans contributed by the Bank. USB Investment Trust was originally formed to give the Bank flexibility in raising capital, and reduce the expenses associated with holding the assets contributed to USB Investment Trust.
On February 16, 2007, the Company completed its merger with Legacy Bank, N.A., located in Campbell, California, with the acquisition of 100 percent of Legacy’s outstanding common shares. At merger, Legacy Bank’s one branch was merged with and into United Security Bank, a wholly owned subsidiary of the Company. The total value of the merger transaction was $21.5 million, and the shareholders of Legacy Bank received merger consideration consisting of 976,411 shares of common stock of the Company. The merger transaction was accounted for as a purchase transaction, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Legacy Bank based on the fair value of those assets and liabilities. The net of assets acquired and liabilities assumed totaled approximately $8.6 million at the date of the merger. Fair value of Legacy assets and liabilities acquired, including resultant goodwill of approximately $8.8 million. (See Note 25 to the Company’s consolidated financial statements contained herein for details of the merger).
During November 2007, the Company purchased the recurring revenue stream and certain fixed assets from ICG Financial, LLC. Additionally, the Company hired all but one of the former employees of ICG Financial, LLC and its subsidiaries. The total purchase price was $414,000 including $378,000 for the recurring revenue stream and $36,000 for the fixed assets. ICG Financial, LLC provided wealth management, employee benefit, insurance and loan products, as well as consulting services for a variety of clients. Now operating as a newly formed department of the Bank, USB Financial Services provides those same services utilizing the employees hired from ICG Financial LLC. The Company believes the wealth management and related services provided by USB Financial Services will enhance the products and services offered by the Company, and increase noninterest income. The capitalized cost of $378,000 for the recurring revenue stream is being amortized over a period of approximately three years, and is tested periodically for impairment. During the fourth quarter of 2008, the Company reviewed the purchased revenue intangible for impairment and determined that the intangible asset was impaired. As a result the Company recorded an impairment loss of approximately $24,000 during the fourth quarter, thus reducing carrying value the intangible asset.
The Bank was founded in 1987 and currently operates eleven branches and one construction lending office in an area from eastern Madera County to western Fresno County, as well as Taft and Bakersfield in Kern County, and Campbell in Santa Clara County. The Bank also operates one financial services department located in Fresno, California. The Bank’s primary source of revenue is providing loans to customers, who are predominantly small and middle-market businesses and individuals. The Bank engages in a full compliment of lending activities, including real estate mortgage, commercial and industrial, real estate construction, agricultural and consumer loans, with particular emphasis on short and medium term obligations.
The Bank offers a wide range of deposit instruments. These include personal and business checking accounts and savings accounts, interest-bearing negotiable order of withdrawal ("NOW") accounts, money market accounts and time certificates of deposit. Most of the Bank's deposits are attracted from individuals and from small and medium-sized business-related sources.
The Bank also offers a wide range of specialized services designed to attract and service the needs of commercial customers and account holders. These services include cashiers checks, travelers checks, money orders, and foreign drafts. In addition, the Bank offers Internet banking services to its commercial and retail customers, and offers certain financial and wealth management services through its financial services department. The Bank does not operate a trust department, however it makes arrangements with its correspondent bank to offer trust services to its customers upon request.
Use of Estimates in the Preparation of Financial Statements - The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 revenue and expenses during the reporting period. Actual results could differ from those estimates.
Material estimates that are particularly susceptible to significant change, relate to the determination of the allowance for loan losses, determination of goodwill, fair value of junior subordinated debt and certain collateralized mortgage obligations, and the valuation of real estate acquired in connection with foreclosures or in satisfaction of loans. In connection with the determination of the allowance for loan losses and the valuation of foreclosed assets held for sale, management obtains independent appraisals for significant properties.
Significant Accounting Policies - The accounting and reporting policies of the Company conform to generally accepted accounting principles and to prevailing practices within the banking industry. The following is a summary of significant policies:
| a. | Cash and cash equivalents – Cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and repurchase agreements. At times throughout the year, balances can exceed FDIC insurance limits. Generally, federal funds sold and repurchase agreements are sold for one-day periods. Repurchase agreements are with a registered broker-dealer affiliated with a correspondent bank and work much like federal funds sold, except that the transaction is collateralized by various investment securities. The securities collateralizing such transactions generally consist of U.S. Treasuries, U.S. Government and U.S. Government-sponsored agencies. The Bank did not have any repurchase agreements during 2008 or 2007, or at December 31, 2008 or 2007. All cash and cash equivalents have maturities when purchased of three months or less. |
| b. | Securities - Debt and equity securities classified as available for sale are reported at fair value, with unrealized gains and losses excluded from net income and reported, net of tax, as a separate component of comprehensive income and shareholders’ equity. Debt securities classified as held to maturity are carried at amortized cost. Gains and losses on disposition are reported using the specific identification method for the adjusted basis of the securities sold. |
The Company classifies its securities as available for sale or held to maturity, and periodically reviews its investment portfolio on an individual security basis. Securities that are to be held for indefinite periods of time (including, but not limited to, those that management intends to use as part of its asset/liability management strategy, those which may be sold in response to changes in interest rates, changes in prepayments or any such other factors) are classified as securities available for sale. Securities which the Company has the ability and intent to hold to maturity are classified as held to maturity.
Declines in fair value of individual held-to-maturity and available-for-sale securities below their cost that are other than temporary are recognized by write-downs of the individual securities to fair value. Such write-downs would be included in earnings as realized losses. Premiums and discounts are recognized in interest income using the interest method over the period to maturity.
Investments with fair values that are less than amortized cost are considered impaired. Impairment may result from either a decline in the financial condition of the issuing entity or, in the case of fixed interest rate investments, from rising interest rates. At each financial statement date, management assesses each investment to determine if impaired investments are temporarily impaired or if the impairment is other-than-temporary based upon the positive and negative evidence available. Evidence evaluated includes, but is not limited to, industry analyst reports, credit market conditions, and interest rate trends. If negative evidence outweighs positive evidence that the carrying amount is recoverable within a reasonable period of time, the impairment is deemed to be other-than-temporary and the security is written down in the period in which such determination is made.
| c. | Loans - Interest income on loans is credited to income as earned and is calculated by using the simple interest method on the daily balance of the principal amounts outstanding. Loans are placed on non-accrual status when principal or interest is past due for 90 days and/or when management believes the collection of amounts due is doubtful. For loans placed on nonaccrual status, the accrued and unpaid interest receivable may be reversed at management's discretion based upon management's assessment of collectibility, and interest is thereafter credited to principal to the extent necessary to eliminate doubt as to the collectibility of the net carrying amount of the loan. |
| | Nonrefundable fees and related direct costs associated with the origination or purchase of loans are deferred and netted against outstanding loan balances. The net deferred fees and costs are generally amortized into interest income over the loan term using the interest method. Other credit-related fees, such as standby letter of credit fees, loan placement fees and annual credit card fees are recognized as noninterest income during the period the related service is performed. |
| | Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or as a practical expedient at the loan’s observable market rate or the fair value of the collateral if the loan is collateral dependent. |
| d. | Allowance for Credit Losses and Reserve for Unfunded Loan Commitments - The allowance for credit losses is maintained to provide for losses that can reasonably be anticipated. The allowance is based on ongoing quarterly assessments of the probable losses inherent in the loan portfolio, and to a lesser extent, unfunded loan commitments. The reserve for unfunded loan commitments is a liability on the Company’s consolidated financial statements and is included in other liabilities. The liability is computed using a methodology similar to that used to determine the allowance for credit losses, modified to take into account the probability of a drawdown on the commitment. |
The allowance for credit losses is increased by provisions charged to operations during the current period and reduced by loan charge-offs net of recoveries. Loans are charged against the allowance when management believes that the collection of the principal is unlikely. The allowance is an amount that management believes will be adequate to absorb losses inherent in existing loans, based on evaluations of the probability of collection. In evaluating the probability of collection, management is required to make estimates and assumptions that affect the reported amounts of loans, allowance for credit losses and the provision for credit losses charged to operations. Actual results could differ significantly from those estimates. These evaluations take into consideration such factors as the composition of the portfolio, overall portfolio quality, loan concentrations, specific problem loans, and current economic conditions that may affect the borrowers' ability to pay. The Company’s methodology for assessing the adequacy of the allowance for credit losses consists of several key elements, which include the formula allowance, specific allowances, and the unallocated allowance.
The formula allowance is calculated by applying loss factors to outstanding loans and certain unfunded loan commitments. Loss factors are based on the Company’s historical loss experience and may be adjusted for significant factors that, in management's judgment, affect the collectibility of the portfolio as of the evaluation date. The Company determines the loss factors for problem-graded loans (substandard, doubtful, and loss), special mention loans, and pass graded loans, based on a loss migration model. The migration analysis incorporates the Company’s losses over the past twelve quarters (three years) and loss factors are adjusted to recognize and quantify the loss exposure from changes in market conditions and trends in the loan portfolio. For purposes of this analysis, loans are grouped by internal risk classifications, which are “pass”, “special mention”, “substandard”, “doubtful”, and “loss”. Certain loans are homogenous in nature and are therefore pooled by risk grade. These homogenous loans include consumer installment and home equity loans. Special mention loans are currently performing but are potentially weak, as the borrower has begun to exhibit deteriorating trends, which if not corrected, could jeopardize repayment of the loan and result in further downgrade. Substandard loans have well-defined weaknesses which, if not corrected, could jeopardize the full satisfaction of the debt. A loan classified as “doubtful” has critical weaknesses that make full collection of the obligation improbable. Classified loans, as defined by the Company, include loans categorized as substandard, doubtful, and loss.
Specific allowances are established based on management’s periodic evaluation of loss exposure inherent in classified loans, impaired loans, and other loans in which management believes it is probable that a loss has been incurred in excess of the amount determined by the application of the formula allowance.
The unallocated portion of the allowance is based upon management’s evaluation of various conditions that are not directly measured in the determination of the formula and specific allowances. The conditions may include, but are not limited to, general economic and business conditions affecting the key lending areas of the Company, credit quality trends, collateral values, loan volumes and concentration, and other business conditions.
The allowance analysis also incorporates the results of measuring impaired loans as provided in Statement of Financial Accounting Standards (“SFAS”) No. 114, “Accounting by Creditors for Impairment of a Loan” and SFAS 118, “Accounting by Creditors for Impairment of a Loan - Income Recognition and Disclosures”. A loan is considered impaired when management determines that it is probable that the Company will be unable to collect all amounts due according to the original contractual terms of the loan agreement. Impairment is measured by the difference between the original recorded investment in the loan and the estimated present value of the total expected cash flows, discounted at the loan’s effective rate, or the fair value of the collateral, if the loan is collateral dependent. Any differences in the specific allowance amounts calculated in the impaired loan analysis and the migration analysis are reconciled by management and changes are made to the allowance as deemed necessary.
| e. | Loans held-for-sale - Loans originated and designated as held-for-sale are carried at the lower of cost or estimated fair value, as determined by quoted market prices, in aggregate. Net unrealized losses are recognized in a valuation allowance by charges to income. Gains or losses on the sale of such loans are based on the specific identification method. The Company held no loans for sale at December 31, 2008 or 2007. |
| f. | Premises and Equipment - Premises and equipment are carried at cost less accumulated depreciation. Depreciation expense is computed principally on the straight-line method over the estimated useful lives of the assets. Estimated useful lives are as follows: |
| Buildings 31Years | Furniture and equipment | 3-7 Years |
| g. | Other Real Estate Owned - Real estate properties acquired through, or in lieu of, loan foreclosure are to be sold and are initially recorded at fair value of the property, less estimated costs to sell. The excess, if any, of the loan amount over the fair value is charged to the allowance for credit losses. Subsequent declines in the fair value of other real estate owned, along with related revenue and expenses from operations, are charged to noninterest expense at foreclosure. |
| | Intangible Assets and Goodwill - Intangible assets are comprised of core deposit intangibles, other specific identifiable intangibles, and goodwill acquired in branch acquisitions in which the fair value of the liabilities assumed exceeded the fair value of the assets acquired. Intangible assets and goodwill are reviewed at least annually for impairment . Core deposit intangibles of $2,278,000 and $3,611,000 (net of accumulated amortization and impairment losses of $4,719,000 and accumulated amortization of $3,386,000) at December 31, 2008 and 2007 are amortized over the estimated useful lives of the existing deposit bases (average of 7 years) using a method which approximates the interest method. Other specific identifiable intangibles resulting from the purchase of certain bank branches during 1997, which were non self-sustaining businesses, of $517,000 and $653,000 (net accumulated amortization of $1.4 million and $1.3 million) at December 31, 2008 and 2007 are being amortized using a method which approximates the interest method over a period of 15 years. The identifiable intangible asset resulting from the purchase of the recurring income stream from ICG Financial Services totaled $206,000 at December 31, 2008 (net accumulated amortization of $147,000 and impairment losses of $24,000) and is being amortized over a period of three years. |
During the first quarter of 2008, the Company recognized an impairment loss of $623,000 on the core deposit intangible related to the deposits purchased in the Legacy merger consummated during February 2007. During the fourth quarter of 2008, the Company recognized an additional impairment loss of $24,000 on the identifiable intangible asset related to the purchased revenue of ICG Financial Services.
The estimated aggregate amortization expense related to intangible assets for each of the five succeeding years is as follows (in 000’s):
Year | | Amortization expense | |
| 2009 | | $ | 749 | |
| 2010 | | | 657 | |
| 2011 | | | 481 | |
| 2012 | | | 349 | |
| 2013 | | | 187 | |
| Total | | $ | 2,423 | |
Goodwill amounts resulting from the acquisitions of Taft National Bank during April 2004, and Legacy Bank during February 2007 are considered to have an indefinite life and are not amortized. At December 31, 2008 goodwill related to Taft National Bank totaled $1.6 million, and goodwill related to Legacy Bank totaled $8.8 million. Pursuant to SFAS No. 142, Goodwill and Other Intangible Assets, goodwill is evaluated annually for impairment. Impairment testing of goodwill is performed during April of each year at a reporting unit level for Taft, and will be performed during March of each year for Legacy. The Company had no impairment adjustments related to goodwill during 2008, 2007, or 2006.
| i. | Income Taxes - Deferred income taxes are provided for the temporary differences between the financial reporting basis and the tax basis of the Company's assets and liabilities using the liability method, and are reflected at currently enacted income tax rates applicable to the period in which the deferred tax assets or liabilities are expected to be realized or settled. |
| j. | Net Income per Share - Basic income per common share is computed based on the weighted average number of common shares outstanding. Diluted income per share includes the effect of stock options and other potentially dilutive securities using the treasury stock method. |
| k. | Cash Flow Reporting - For purposes of reporting cash flows, cash and cash equivalents include cash on hand, noninterest-bearing amounts due from banks, federal funds sold and securities purchased under agreements to resell. Federal funds and securities purchased under agreements to resell are generally sold for one-day periods. |
| l. | Transfers of Financial Assets - Transfers of financial assets are accounted for as sales when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity. |
| m. | Advertising Costs - The Company expenses marketing costs as they are incurred. Advertising expense was $121,000, $113,000, and $105,000 for the years ended December 31, 2008, 2007 and 2006, respectively. |
| n. | Stock Based Compensation - At December 31, 2008, the Company has a stock-based employee compensation plan, which is described more fully in Note 12. The Company accounts for the stock-based employee compensation plan pursuant to the provisions of Financial Accounting Standards Board (FASB) Statement No. 123 R, “Accounting for Share-Based Payments”. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on the grant-date fair value of the award. The fair value is amortized over the requisite service period (generally the vesting period). Included in salaries and employee benefits for the years ended December 31, 2008, 2007 and 2006 is $110,000, $187,000 and $248,000, respectively, of share-based compensation. The related tax benefit, recorded in the provision for income taxes, was not significant. |
| o. | Long-Lived Assets - The Company periodically evaluates the carrying value of long-lived assets to be held and used, including other specific intangible assets, and core deposit intangible assets in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Based on such evaluation, the Company recognized impairment losses of $623,000 and $24,000 on core deposits intangible assets and the identifiable intangible asset related to the purchased revenue of ICG Financial Services, respectively, during 2008. The Company determined that there was no impairment of long-lived assets 2007 or 2006. |
| p. | Derivative Financial Instruments - All derivative instruments (including certain derivative instruments embedded in other contracts) are recognized in the consolidated balance sheet at fair value. The Company’s accounting treatment for gains or losses from changes in the derivative instrument’s fair value is contingent on whether the derivative instrument qualifies as a hedge. On the date the Company enters into a derivative contract, the Company designates the derivative instruments as (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge), (2) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge) or (3), a hedge for trading, customer accommodation or not qualifying for hedge accounting (free-standing derivative instruments). For a fair value hedge, changes in the fair value of the derivative instrument and changes in the fair value of the hedged asset or liability or of an unrecognized firm commitment attributable to the hedged risk are recorded in current period net income. For a cash flow hedge, changes in the fair value of the derivative instrument to the extent that it is highly effective are recorded in other comprehensive income, net of tax, within shareholders’ equity and subsequently reclassified to net income in the same period(s) that the hedged transaction impacts net income. For freestanding derivative instruments, changes in the fair values are reported in current period net income. The Company formally documents the relationship between hedging instruments and hedged items, as well as the risk management objective and strategy for undertaking any hedge transaction. This process includes relating all derivative instruments that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or to specific forecasted transactions. The Company also formally assesses both at the inception of the hedge and on an ongoing basis, whether the derivative instruments used are highly effective in offsetting changes in fair values or cash flows of hedged items. If it is determined that the derivative instrument is not, and will not be, highly effective as a hedge, hedge accounting is discontinued. |
| q. | Federal Home Loan Bank stock and Federal Reserve Stock - As a member of the Federal Home Loan Bank (FHLB), the Company is required to maintain an investment in capital stock of the FHLB. In addition, as a member of the Federal Reserve Bank (FRB), the Company is required to maintain an investment in capital stock of the FRB. The investments in both the FHLB and the FRB are carried at cost in the accompanying consolidated balance sheets under other assets and are subject to certain redemption requirements by the FHLB and FRB. |
| r. | Comprehensive Income -Comprehensive income is comprised of net income and other comprehensive income. Other comprehensive income includes items previously recorded directly to equity, such as unrealized gains and losses on securities available-for-sale, unrecognized costs of salary continuation defined benefit plans, and certain derivative instruments used as a cash flow hedge. Comprehensive income is presented in the consolidated statement of shareholders’ equity. |
| s. | Segment Reporting - The Company's operations are solely in the financial services industry and include providing to its customers traditional banking and other financial services. The Company operates primarily in the San Joaquin Valley region of California. Management makes operating decisions and assesses performance based on an ongoing review of the Company's consolidated financial results. Therefore, the Company has a single operating segment for financial reporting purposes. |
| t. | New Accounting Standards: |
Statements of Financial Accounting Standards
In December 2007, the FASB issued SFAS No. 160, "Noncontrolling Interests in Consolidated Financial Statements," which provides guidance for accounting and reporting of noncontrolling (minority) interests in consolidated financial statements. The statement is effective for fiscal years and interim periods within fiscal years beginning on or after December 15, 2008. The Company does not hold minority interests in subsidiaries, therefore it is expected that SFAS No. 160 will have no impact on its financial condition or results of operations.
In February 2007, the FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115. SFAS 159 allows entities to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and financial liabilities that are not otherwise required to be measured at fair value, with changes in fair value recognized in earnings as they occur. SFAS 159 also requires entities to report those financial assets and financial liabilities measured at fair value in a manner that separates those reported fair values from the carrying amounts of similar assets and liabilities measured using another measurement attribute on the face of the statement of financial position. Lastly, SFAS 159 establishes presentation and disclosure requirements designed to improve comparability between entities that elect different measurement attributes for similar assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007, with early adoption permitted if an entity also early adopts the provisions of SFAS 157. Effective January 1, 2007, the Company elected early adoption of the fair value option to value its junior subordinated debt. The initial impact upon adoption of SFAS No. 159 was to record a $1.3 million loss, reflected as an adjustment to beginning retained earnings at January 1, 2007. Subsequent to adoption, the Company recorded total gains resulting from fair value adjustments on its junior subordinated debt totaling $2.5 million during the year ended December 31, 2007, which are reflected as a component of other noninterest income. (see Note 9).
In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans (“SFAS No. 158”). SFAS No. 158 amends SFAS No. 87 and SFAS No. 106. SFAS No. 158 amends previous applicable accounting statements and requires companies to better disclose, among other things, the funded status of benefit plans, and to recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost pursuant to FASB Statement No. 87, Employers’ Accounting for Pensions, or No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. Amounts recognized in accumulated other comprehensive income, including the gains or losses, prior service costs or credits, and the transition asset or obligation remaining from the initial application of Statements 87 and 106, are adjusted as they are subsequently recognized as components of net periodic benefit cost pursuant to the recognition and amortization provisions of those Statements. SFAS No. 158 is effective for public companies with fiscal years ending after December 15, 2006. The Company adopted SFAS No. 158 effective December 31, 2006, and has made required disclosures since December 31, 2006. As a result, the Company upon adoption at December 31, 2006, recorded $169,000 in accumulated other comprehensive income (net tax of $112,000) for the previously unrecognized cost of post-retirement benefits related to the Company’s Salary Continuation Plan, and had $8,000 in other comprehensive income (net tax of $5,000) for the excess net periodic benefit costs at December 31, 2008 (see Note 13, Employee Benefit Plans).
In September 2006, the FASB issued SFAS 157, Fair Value Measurements. SFAS No. 157 clarifies the definition of fair value, describes methods used to appropriately measure fair value in accordance with generally accepted accounting principles and expands fair value disclosure requirements. This statement applies whenever other accounting pronouncements require or permit fair value measurements and is effective for fiscal years beginning after November 15, 2007. Effective January 1, 2007, the Company adopted SFAS No. 157 as a result of its early adoption of SFAS No. 159 (see Note 15).
In March 2008, the Financial Accounting Standards Board (FASB) issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities - an Amendment of FASB Statement 133.” SFAS No. 161 enhances required disclosures regarding derivatives and hedging activities, including enhanced disclosures regarding how an entity uses derivative instruments and how derivative instruments and related hedged items are accounted for and affect an entity’s financial position, financial performance, and cash flows. SFAS No. 161 is effective for fiscal years and interim periods beginning after November 15, 2008. Adoption of SFAS No. 161 as of January 1, 2009 has not had a material impact on the Company’s consolidated financial position or results of operations, as it impacts financial statement disclosure only.
Financial Accounting Standards Board Staff Positions and Interpretations
On July 13, 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation 48 (FIN 48), Accounting for Uncertainty in Income Taxes: an interpretation of FASB Statement No. 109. FIN 48 clarifies SFAS No. 109, Accounting for Income Taxes, to indicate a criterion that an individual tax position would have to meet for some or all of the income tax benefit to be recognized in a taxable entity’s financial statements. Under the guidelines of the Interpretation, an entity should recognize the financial statement benefit of a tax position if it determines that it is more likely than not that the position will be sustained on examination. The term “more likely than not” means “a likelihood of more than 50 percent.” In assessing whether the more-likely-than-not criterion is met, the entity should assume that the tax position will be reviewed by the applicable taxing authority. The scope of FIN 48 is broad and includes all tax positions accounted for in accordance with SFAS No. 109. Additionally, besides business enterprises, FIN 48 applies to pass-through entities, and entities whose tax liability is subject to 100 percent credit for dividends paid (such as real estate investment trusts). FIN 48 is effective for the Company beginning after January 1, 2007. The cumulative effect of applying FIN 48 totaling $1.3 million was reported as an adjustment to retained earnings at January 1, 2007 (see Note 11).
In September 2006, the Emerging Issues Task Force (EITF) reached a final consensus on Issue No. 06-4 (EITF 06-4), "Accounting for Deferred Compensation and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance Arrangements." EITF 06-4 requires employers to recognize a liability for future benefits provided through endorsement split-dollar life insurance arrangements that extend into postretirement periods in accordance with SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions or APB Opinion No. 12, Omnibus Opinion-1967." The provisions of EITF 06-4 become effective on January 1, 2008 and are to be applied as a change in accounting principle either through a cumulative-effect adjustment to retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the year of adoption, or through retrospective application to all prior periods. The Company's split-dollar life insurance benefits are limited to the employee's active service period. Therefore EITF 06-4 did not have a significant impact on the Company’s financial condition or results of operations.
FASB Staff Position (FSP) No. 157-2. FSP 157-2 delays the effective date of SFAS 157, Fair Value Measurements, for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). The delay is intended to allow the FASB and constituents additional time to consider the effect of various implementation issues that have arisen, or that may arise, from the application of SFAS 157. This FSP defers the effective date of SFAS 157 to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years for items within the scope of this FSP. FSP 157-2 was effective for the Company on January 1, 2009 and did not have a significant impact on the Company’s financial statements.
FASB Staff Position No. 157-3. On October 10, 2008, the FASB issued FASB Staff Position 157- 3 (“FSP 157-3”) Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. FSP 157-3 applies to financial assets within the scope of SFAS 157. FSP 157-3 clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. In situations in which there is little, if any, market activity for an asset at the measurement date, the fair value measurement objective remains the same, that is, the price that would be received by the holder of the financial asset in an orderly transaction (an exit price notion) that is not a forced liquidation or distressed sale at the measurement date. Additionally, in determining fair value for a financial asset, the use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available. Broker (or pricing service) quotes may be an appropriate input when measuring fair value, but they are not necessarily determinative if an active market does not exist for the financial asset. FSP 157-3 was effective for the Company on September 30, 2008. Although FSP 157-3 did not have a significant impact on the Company’s financial statements at December 31, 2008, it did provide additional guidance used in the Company’s evaluation of fair value at December 31, 2008.
On January 12, 2009, the FASB staff issued FASB Staff Position (FSP) EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20, which eliminated the reference to the “market participant” view of expected cash flows when making impairment determinations for certain beneficial interests in securitized financial instruments. The guidance is intended to reduce complexity and achieve a more consistent determination of whether other-than-temporary impairments of available-for-sale and held-to-maturity debt securities have occurred by aligning the impairment guidance for certain beneficial interests with the impairment guidance for other debt securities. FSP 99-20-1 was effective for the Company for reporting periods ending after December 15, 2008. The Company adopted FSP 99-20-1 effective December 31, 2008 and utilized the revised method, the effects of which are included in the Company’s financial statements at December 31, 2008.
| v. | Reclassifications - Certain reclassifications have been made to the 2007 and 2006 financial statements to conform to the classifications used in 2008. |
Following is a comparison of the amortized cost and approximate fair value of investment securities for the years ended December 31, 2008 and December 31, 2007:
| (In thousands) | | | | | Gross | | | Gross | | | Fair Value | |
| | | Amortized | | | Unrealized | | | Unrealized | | | (Carrying | |
| | | Cost | | | Gains | | | Losses | | | Amount) | |
| December 31, 2008: | | | | | | | | | | | | |
| Securities available for sale: | | | | | | | | | | | | |
| U.S. Government agencies | | $ | 43,110 | | | $ | 1,280 | | | $ | (204 | ) | | $ | 44,186 | |
| Collateralized mortgage obligations | | | 39,068 | | | | 189 | | | | (4,991 | ) | | | 34,266 | |
| Obligations of state and political subdivisions | | | 1,252 | | | | 28 | | | | 0 | | | | 1,280 | |
| Other investment securities | | | 13,880 | | | | 0 | | | | (863 | ) | | | 13,017 | |
| Total securities available for sale | | $ | 97,310 | | | $ | 1,497 | | | $ | (6,058 | ) | | $ | 92,749 | |
| December 31, 2007: | | | | | | | | | | | | | | | | |
| Securities available for sale: | | | �� | | | | | | | | | | | | | |
| U.S. Government agencies | | $ | 65,764 | | | $ | 524 | | | $ | (302 | ) | | $ | 65,986 | |
| Collateralized mortgage obligations | | | 7,782 | | | | 44 | | | | (4 | ) | | | 7,822 | |
| Obligations of state and political subdivisions | | | 2,227 | | | | 54 | | | | 0 | | | | 2,281 | |
| Other investment securities | | | 13,752 | | | | 0 | | | | (426 | ) | | | 13,326 | |
| Total securities available for sale | | $ | 89,525 | | | $ | 622 | | | $ | (732 | ) | | $ | 89,415 | |
Included in other investment securities at December 31, 2008, is a short-term government securities mutual fund totaling $7.2 million, a CRA-qualified mortgage fund totaling $4.9 million, and an overnight money-market mutual fund totaling $880,000. Included in other investment securities at December 31, 2007, is a short-term government securities mutual fund totaling $7.7 million, a CRA-qualified mortgage fund totaling $4.9 million, and an overnight money-market mutual fund totaling $752,000. The commercial asset-backed trust consists of fixed and floating rate commercial and multifamily mortgage loans. The short-term government securities mutual fund invests in debt securities issued or guaranteed by the U.S. Government, its agencies or instrumentalities, with a maximum duration equal to that of a 3-year U.S. Treasury Note.
Management periodically evaluates each available-for-sale investment security in an unrealized loss position to determine if the impairment is temporary or other-than-temporary. Management has determined that no investment security is other than temporarily impaired. The unrealized losses are due in most part to interest rate changes, as well as credit downgrades in some of the portfolio including three collateralized mortgage obligations. The Company has the ability and intent to hold all investment securities with identified impairments resulting from interest rate changes and credit downgrades to the earlier of the forecasted recovery or the maturity of the underlying investment security. The Company believes that credit downgrades on securities within the portfolio are a result of the severity of the current economic downturn and does not believe the downgrades will result in other-than-temporary impairment of those securities.
The following summarizes temporarily impaired investment securities at December 31, 2008 and 2007:
| | | Less than 12 Months | | | 12 Months or More | | | Total | |
| (In thousands) | | Fair Value | | | | | | Fair Value | | | | | | Fair Value | | | | |
| | | (Carrying | | | Unrealized | | | (Carrying | | | Unrealized | | | (Carrying | | | Unrealized | |
| | | Amount) | | | Losses | | | Amount) | | | Losses | | | Amount) | | | Losses | |
| December 31, 2008: | | | | | | | | | | | | | | | | | | |
| Securities available for sale: | | | | | | | | | | | | | | | | | | |
| U.S. Government agencies | | $ | 6,471 | | | $ | (204 | ) | | $ | 0 | | | $ | 0 | | | $ | 6,471 | | | $ | (204 | ) |
| Collateralized mortgage obligations | | | 17,568 | | | | (4,991 | ) | | | 0 | | | | 0 | | | | 17,568 | | | | (4,991 | ) |
| Obligations of state and political subdivisions | | | 0 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | |
| Other investment securities | | | 0 | | | | 0 | | | | 12,137 | | | | (863 | ) | | | 12,137 | | | | (863 | ) |
| Total impaired securities | | $ | 24,039 | | | $ | (5,195 | ) | | $ | 12,137 | | | $ | (863 | ) | | $ | 36,176 | | | $ | (6,058 | ) |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| December 31, 2007: | | | | | | | | | | | | | | | | | | | | | | | | |
| Securities available for sale: | | | | | | | | | | | | | | | | | | | | | | | | |
| U.S. Government agencies | | $ | 0 | | | $ | 0 | | | $ | 30,241 | | | $ | (302 | ) | | $ | 30,241 | | | $ | (302 | ) |
| Collateralized mortgage obligations | | | 4,129 | | | | (4 | ) | | | 0 | | | | 0 | | | | 4,129 | | | | (4 | ) |
| Obligations of state and political subdivisions | | | 0 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | |
| Other investment securities | | | 0 | | | | 0 | | | | 12,574 | | | | (426 | ) | | | 12,574 | | | | (426 | ) |
| Total impaired securities | | $ | 4,129 | | | $ | (4 | ) | | $ | 42,815 | | | $ | (728 | ) | | $ | 46,944 | | | $ | (732 | ) |
Temporarily impaired securities at December 31, 2008 are comprised of four (4) collateralized mortgage obligations, seven (7) U.S. government agency securities, and two (2) other investment securities, with a total weighted average life of 3.1 years.
Temporarily impaired securities at December 31, 2007 are comprised of nine (9) U.S. government agency securities, one U.S. agency collateralized mortgage obligation, and two other investment securities, with a total weighted average life of 1.0 years.
There were gross realized gains on sales of available-for-sale securities totaling $24,000, and $27,000 during the years ended December 31, 2008, and 2006, respectively. There were no gross realized gains or losses on available-for-sale securities during the year ended December 31, 2007. There were no gross realized losses on available-for-sale securities during the year ended December 31, 2008 or 2006.
The amortized cost and fair value of securities available for sale at December 31, 2008, by contractual maturity, are shown below. Actual maturities may differ from contractual maturities because issuers have the right to call or prepay obligations with or without call or prepayment penalties. Contractual maturities on collateralized mortgage obligations cannot be anticipated due to allowed paydowns.
| | | December 31, 2008 | |
| | | Amortized | | | Fair Value | |
| (In thousands) | | Cost | | | (Carrying Amount) | |
| Due in one year or less | | $ | 14,577 | | | $ | 13,717 | |
| Due after one year through five years | | | 3,866 | | | | 3,994 | |
| Due after five years through ten years | | | 9,148 | | | | 9,529 | |
| Due after ten years | | | 30,652 | | | | 31,243 | |
| Collateralized mortgage obligations | | | 39,067 | | | | 34,266 | |
| | | $ | 97,310 | | | $ | 92,749 | |
At December 31, 2008 and 2007, available-for-sale securities with an amortized cost of approximately $81.4 million and $71.0 million (fair value of $79.6 million and $71.3 million) were pledged as collateral for public funds, treasury tax and loan balances, and repurchase agreements.
The Company had no held-to-maturity or trading securities at December 31, 2008 or 2007.
3. Loans
| | Loans are comprised of the following: |
| | | December 31, | |
| (In thousands) | | 2008 | | | 2007 | |
| Commercial and industrial | | $ | 223,581 | | | $ | 204,385 | |
| Real estate – mortgage | | | 126,689 | | | | 142,565 | |
| Real estate – construction | | | 119,884 | | | | 178,296 | |
| Agricultural | | | 52,020 | | | | 46,055 | |
| Installment | | | 20,782 | | | | 18,171 | |
| Lease financing | | | 7,020 | | | | 8,748 | |
| Total Loans | | $ | 549,976 | | | $ | 598,220 | |
The Company's loans are predominantly in the San Joaquin Valley, and the greater Oakhurst/East Madera County area, as well as the Campbell area of Santa Clara County, although the Company does participate in loans with other financial institutions, primarily in the state of California.
Commercial and industrial loans represent 40.7% of total loans at December 31, 2008 and have a high degree of industry diversification. A substantial portion of the commercial and industrial loans are secured by accounts receivable, inventory, leases or other collateral including real estate. The remainder are unsecured; however, extensions of credit are predicated upon the financial capacity of the borrower. Repayment of commercial loans is generally from the cash flow of the borrower.
Real estate mortgage loans, representing 23.0% of total loans at December 31, 2008, are secured by trust deeds on primarily commercial property. Repayment of real estate mortgage loans is generally from the cash flow of the borrower.
Real estate construction loans, representing 21.7% of total loans at December 31, 2008, consist of loans to residential contractors, which are secured by single-family residential properties. All real estate loans have established equity requirements. Repayment on construction loans is generally from long-term mortgages with other lending institutions.
Agricultural loans represent 9.5% of total loans at December 31, 2008 and are generally secured by land, equipment, inventory and receivables. Repayment is from the cash flow of the borrower.
Lease financing loans, representing 1.3% of total loans at December 31, 2008, consist of loans to small businesses, which are secured by commercial equipment. Repayment of the lease obligation is from the cash flow of the borrower.
Occasionally, shared appreciation agreements are made between the Company and the borrower on certain construction loans where the Company agrees to receive interest on the loan at maturity rather than monthly and the borrower agrees to share in the profits of the project. Due to the difficulty in calculating future values, shared appreciation income is recognized when received. The Company does not participate in a significant number of shared appreciation projects. Shared appreciation income totaled $265,000, $42,000, and $567,000 for the years ended December 31, 2008, 2007, and 2006, respectively.
Loans over 90 days past due and still accruing totaled $680,000 and $189,000 at December 31, 2008 and December 31, 2007, respectively. Nonaccrual loans totaled $51.1 million and $21.6 million at December 31, 2008 and 2007, respectively. There were remaining undisbursed commitments to extend credit on nonaccrual loans of $1.6 million and $12,000 at December 31, 2008 and December 31, 2007, respectively. The interest income that would have been earned on nonaccrual loans outstanding at December 31, 2008 in accordance with their original terms is approximately $3.7 million. There was no interest income recorded on such loans during the year ended December 31, 2008 and 2007. The interest income recorded on such loans during 2006 totaled $65,000.
The Company has, and expects to have, lending transactions in the ordinary course of its business with directors, officers, principal shareholders and their affiliates. These loans are granted on substantially the same terms, including interest rates and collateral, as those prevailing on comparable transactions with unrelated parties, and do not involve more than the normal risk of collectibility or present unfavorable features.
Loans to directors, officers, principal shareholders and their affiliates are summarized below:
| | | December 31, | |
| (In thousands) | | 2008 | | | 2007 | |
| Aggregate amount outstanding, beginning of year | | $ | 7,436 | | | $ | 1,605 | |
| New loans or advances during year | | | 13,667 | | | | 9,734 | |
| Repayments during year | | | (3,242 | ) | | | (3,903 | ) |
| Aggregate amount outstanding, end of year | | $ | 17,861 | | | $ | 7,436 | |
| Loan commitments | | $ | 8,380 | | | $ | 6,799 | |
An analysis of changes in the allowance for credit losses is as follows:
| | | Years Ended December 31, | |
| (In thousands) | | 2008 | | | 2007 | | | 2006 | |
| Balance, beginning of year | | $ | 10,901 | | | $ | 8,365 | | | $ | 7,748 | |
| Provision charged to operations | | | 9,598 | | | | 5,697 | | | | 880 | |
| Losses charged to allowance | | | (5,545 | ) | | | (4,493 | ) | | | (502 | ) |
| Recoveries on loans previously charged off | | | 117 | | | | 64 | | | | 239 | |
| Reserve acquired in merger | | | 0 | | | | 1,268 | | | | — | |
| Balance at end-of-period | | $ | 15,071 | | | $ | 10,901 | | | $ | 8,365 | |
The allowance for credit losses represents management's estimate of the risk inherent in the loan portfolio based on the current economic conditions, collateral values and economic prospects of the borrowers. Significant changes in these estimates might be required in the event of a downturn in the economy and/or the real estate markets in the San Joaquin Valley, the greater Oakhurst and East Madera County area, and in Santa Clara County.
At December 31, 2008 and 2007, the Company's recorded investment in loans for which impairment has been recognized totaled $54.4 million and $20.6 million, respectively. Included in total impaired loans at December 31, 2008 are $31.0 million of impaired loans for which the related specific allowance is $8.5 million, as well as $23.4 million of impaired loans that as a result of write-downs or the fair value of the collateral, did not have a specific allowance. At December 31, 2007, total impaired loans included $10.7 million for which the related specific allowance is $4.5 million, as well as $9.9 million of impaired loans that as a result of write-downs to the fair value of the collateral did not have a specific allowance. The average recorded investment in impaired loans was $37.1 million, $15.9 million, and $10.1 million for the years ended December 31, 2008, 2007, and 2006, respectively. In most cases, the Company uses the cash basis method of income recognition for impaired loans. In the case of certain troubled debt restructuring for which the loan is performing under the current contractual terms for a reasonable period of time, income is recognized under the accrual method. For the year ended December 31, 2008 and 2007, the Company recognized no income on impaired loans. For the year ended December 31, 2006, the Company recognized income of $65,000 on such loans.
In the normal course of business, the Company is party to financial instruments with off-balance sheet risk to meet the financing needs of its customers. At December 31, 2008 and 2007 these financial instruments include commitments to extend credit of $112.3 million and $196.3 million, respectively, and standby letters of credit of $7.1 million and $6.7 million, respectively. These instruments involve elements of credit risk in excess of the amount recognized on the balance sheet. The contract amounts of these instruments reflect the extent of the involvement the Company has in off-balance sheet financial instruments.
The Company’s exposure to credit loss in the event of nonperformance by the counterparty to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amounts of those instruments. The Company uses the same credit policies as it does for on-balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer, as long as there is no violation of any condition established in the contract. Substantially all of these commitments are at floating interest rates based on the Prime rate. Commitments generally have fixed expiration dates. The Company evaluates each customer's creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary, is based on management's credit evaluation. Collateral held varies but includes accounts receivable, inventory, leases, property, plant and equipment, residential real estate and income-producing properties.
Standby letters of credit are generally unsecured and are issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.
| 4. | Lease Assets held for Sale |
The Company had a lease portfolio totaling $7.0 million and $8.7 million at December 31, 2008 and December 31, 2007, respectively. The lease portfolio is included as a component of total loans. Leases, like other types of loans, may become nonperforming at which time they are foreclosed upon and the remaining lease assets, including equipment and furniture, are transferred to lease assets held for sale which is included in other assets. Valuation adjustments, if required, at the time of foreclosure are charged to the allowance for loan losses. The Company discontinued making new leases during the first quarter of 2007, and since that time the balances in the lease portfolio have declined. The Company previously utilized a third-party broker to aid in the collection and ultimate disposition of lease assets held for sale. During the third quarter of 2007, the Company determined that the third-party broker no longer wished to continue collection and disposition efforts for the Company due to the Company’s exit strategy from the leasing business. During the fourth quarter of 2007, the Company increased its efforts to dispose of existing lease assets held through foreclosure, while during the same period, additional lease assets were being foreclosed upon due to general declines in the economy. As a result, the Company reviewed the collectability of values recorded for lease assets held for sale during the fourth quarter of 2007 and charged-off $820,000 of the lease assets held for sale. The expense is recorded as a component of noninterest expense for the year ended December 31, 2007. At December 31, 2008, the balance of lease assets held for sale was approximately $6,000. The Company did not recognize any impairment on such assets during 2008.
The components of premises and equipment are as follows:
| | | December 31, | |
| (In thousands) | | 2008 | | | 2007 | |
| Land | | $ | 968 | | | $ | 968 | |
| Buildings and improvements | | | 14,212 | | | | 14,160 | |
| Furniture and equipment | | | 9,045 | | | | 8,776 | |
| | | | 24,225 | | | | 23,904 | |
| | | | | | | | | |
| Less accumulated depreciation and amortization | | | (9,940 | ) | | | (8,330 | ) |
| Total premises and equipment | | $ | 14,285 | | | $ | 15,574 | |
During February 2007, the Company purchased Legacy Bank, N.A. in Campbell, California which included net fixed assets totaling $729,000. Included in this amount were buildings and improvements of $631,000, furniture and equipment of $713,000, and accumulated depreciation of $615,000. The Company determined that the net carrying value of Legacy fixed assets reasonably approximated fair value, and therefore did not make any additional fair value adjustments pursuant to purchase accounting guidelines.
Total depreciation expense on Company premises and equipment totaled $1.7 million, $1.6 million, and $1.1 million for the years ended December 31, 2008, 2007 and 2006, respectively, and is included in occupancy expense in the accompanying consolidated statements of income.
| 6. | Investment in Limited Partnership |
The Bank owns limited interests in a private limited partnerships that acquire affordable housing properties in California that generate Low Income Housing Tax Credits under Section 42 of the Internal Revenue Code of 1986, as amended. The Bank's limited partnership investment is accounted for under the equity method. The Bank's noninterest expense associated with the utilization and expiration of these tax credits for the year ended December 31, 2008, 2007 and 2006 was $432,000, $430,000, and $440,000, respectively. The limited partnership investments are expected to generate remaining tax credits of approximately $2.6 million over the life of the investment. The tax credits expire between 2009 and 2014. Tax credits utilized for income tax purposes for the years ended December 31, 2008, 2007, and 2006 totaled $519,000, $545,000, and $547,000, respectively.
Deposits include the following:
| | | December 31, | |
| (In thousands) | | 2008 | | | 2007 | |
| Noninterest-bearing deposits | | $ | 149,529 | | | $ | 139,066 | |
| Interest-bearing deposits: | | | | | | | | |
| NOW and money market accounts | | | 136,612 | | | | 153,717 | |
| Savings accounts | | | 37,586 | | | | 40,012 | |
| Time deposits: | | | | | | | | |
| Under $100,000 | | | 66,128 | | | | 52,297 | |
| $100,000 and over | | | 118,631 | | | | 249,525 | |
| Total interest-bearing deposits | | | 358,957 | | | | 495,551 | |
| Total deposits | | $ | 508,486 | | | $ | 634,617 | |
At December 31, 2008, the scheduled maturities of all certificates of deposit and other time deposits are as follows:
| (In thousands | | | |
| One year or less | | $ | 172,726 | |
| More than one year, but less than or equal to two years | | | 9,037 | |
| More than two years, but less than or equal to three years | | | 2,191 | |
| More than three years, but less than or equal to four years | | | 144 | |
| More than four years, but less than or equal to five years | | | 650 | |
| More than five years | | | 11 | |
| | | $ | 184,759 | |
The Company may utilize brokered deposits as an additional source of funding. At December 31, 2008 and 2007, the Company held brokered time deposits totaling $93.4 million and $139.3 million, with average rates of 2.59% and 4.93%, respectively. Of this balance at December 31, 2008, $68.9 million is included in time deposits of $100,000 or more, and the remaining $24.5 million is included in time deposits of less than $100,000. Included in brokered time deposits at December 31, 2008 are balances totaling $47.1 million maturing in three months or less, $43.7 million maturing in three to six months, $1.6 million maturing in 6 to twelve months, and $850,000 maturing in more than one year.
Deposit balances representing overdrafts reclassified as loan balances totaled $332,000 and $565,000 as of December 31, 2008 and 2007, respectively.
Deposits of directors, officers and other related parties to the Bank totaled $5.0 million and $5.9 million at December 31, 2008 and 2007, respectively. The rates paid on these deposits were those customarily paid to the Bank's customers in the normal course of business.
| 8. | Short-term Borrowings/Other Borrowings |
At December 31, 2008, the Company had collateralized and uncollateralized lines of credit with the Federal Reserve Bank of San Francisco and other correspondent banks aggregating $242.7 million, as well as Federal Home Loan Bank (“FHLB”) lines of credit totaling $97.1 million. At December 31, 2008, the Company had total outstanding balances of $155.0 million in borrowings, including $66.5 million in federal funds purchased from the Federal Reserve Discount Window at an average rate of 0.50%, and $88.5 million drawn against its FHLB lines of credit. Of the $88.5 million in FHLB borrowings outstanding at December 31, 2008, $77.5 million will mature in three months or less with an average rate of 1.1%, and the other $11.0 million consists of a two-year FHLB advance at a fixed rate of 2.67%, and a maturity date of February 11, 2010. The weighted average cost of borrowings for the year ended December 31, 2008 was 2.32%. These lines of credit generally have interest rates tied to the Federal Funds rate or are indexed to short-term U.S. Treasury rates or LIBOR. FHLB advances are collateralized by all of the Company’s stock in the FHLB and certain qualifying mortgage loans. As of December 31, 2008, $59.2 million in real estate-secured loans, $55.8 million in investment securities, and $16.4 million in interest-bearing deposits at FHLB, were pledged as collateral for FHLB advances. Additionally, $268.3 million in real estate-secured loans were pledged at December 31, 2008 as collateral for used and unused borrowing lines with the Federal Reserve Bank totaling $211.2 million. All lines of credit are on an “as available” basis and can be revoked by the grantor at any time.
The Company had collateralized and uncollateralized lines of credit with the Federal Reserve Bank of San Francisco and other correspondent banks aggregating $386.7 million, as well as Federal Home Loan Bank (“FHLB”) lines of credit totaling $22.0 million at December 31, 2007. At December 31, 2007, the Company had total outstanding balances of $32.3 million in borrowings, including $10.4 million in federal funds purchased from correspondent banks at an average rate of 4.2%, and $21.9 million drawn against its FHLB lines of credit.
| 9. | Fair Value – Adoption of SFAS No. 159 |
Effective January 1, 2007, the Company elected early adoption of SFAS No.159, “The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115”. The Company also adopted the provisions of SFAS No. 157, “Fair Value Measurements”, effective January 1, 2007, in conjunction with the adoption of SFAS No. 159. SFAS No. 159 generally permits the measurement of selected eligible financial instruments at fair value at specified election dates. Upon adoption of SFAS No. 159, the Company elected the fair value measurement option for all the Company’s pre-existing junior subordinated debentures with a carrying cost of $15.5 million, prior to the adoption of SFAS No. 159.
The Company believes its adoption of SFAS No. 159 will have a positive impact on its ability to better manage the balance sheet and interest rate risks associated with this liability while potentially benefiting the net interest margin, net interest income, net income and earnings per common share in future periods. Specifically, the Company believes the election of fair value accounting for the junior subordinated debentures better reflects the true economic value of the debt instrument on the balance sheet, although valuations have become more subjective during 2008 and thus susceptible to significant changes as the result of relatively illiquid credit markets. The Company’s junior subordinated debentures were issued in 2001 when the Trust Preferred Securities market was new and less liquid than today. As a result, subordinated debentures are available in the market at narrower spreads and lower issuing costs. With a higher-than-market spread to LIBOR, and remaining capitalized issuance costs of more than $400,000 on the balance sheet, the Company’s cost-basis of the subordinated debentures recorded on the balance sheet does not properly reflect the true opportunity costs to the Company.
The initial fair value measurement at adoption resulted in a $1,053,000 cumulative-effect adjustment to the opening balance of retained earnings at January 1, 2007. The adjustment resulted in an increase of $1,053,000 in the reported balance of the junior subordinated debentures, an increase in deferred tax assets of $443,000 and the corresponding reduction in retained earnings of $610,000. Under SFAS No. 159, this one-time charge to shareholders’ equity was not recognized in earnings. In addition to the fair value adjustment of the junior subordinated debentures recorded effective January 1, 2007, the Company also removed the remaining $405,000 in unamortized issuance costs of the debt instrument. The remaining issuance costs were removed in accordance with SFAS 159 effective January 1, 2007, with corresponding charges of $170,000 to deferred taxes and $235,000 to retained earnings.
As a requirement of electing early adoption of SFAS 159, the Company also adopted SFAS 157, “Fair Value Measurement” effective January 1, 2007. The Company utilized the guidelines of SFAS No. 157 to perform the fair value analysis on the junior subordinated debentures. In its analysis, the Company used a net-present-value approach based upon observable market rates of interest, over a term that considers the most advantageous market for the liability, and the most reasonable behavior of market participants.
The following table summarizes the effects of the adoption of SFAS No. 159 at the adoption date, December 31, 2007, and December 31, 2008 (in 000’s) on the Company’s junior subordinated debentures. Changes in fair value (FV) for periods subsequent to adoption are recorded in current earnings. The pretax change in fair value for the years ended December 31, 2008 and December 31, 2007 totaled $1.4 million and $2.5 million, respectively, and is included as a gain in other noninterest income.
| Balance of junior subordinated debentures at December 31, 2006 | | $ | 15,464 | |
| Adjustments upon adoption: | | | | |
| Combine accrued interest 1/1/07 | | | 613 | |
| Total carrying value 1/1/07 | | | 16,077 | |
| FV adjustment upon adoption of SFAS No. 159 | | | 1,053 | |
| Total FV of junior subordinated debentures at adoption - January 1, 2007 | | $ | 17,130 | |
| | | | | |
| Total FV of junior subordinated debentures at December 31, 2007 | | $ | 13,341 | |
| FV adjustment during 2008 | | | (1,363 | ) |
| Change in accrued interest during 2008 | | | (52 | ) |
| Total FV of junior subordinated debentures at December 31, 2008 | | $ | 11,926 | |
| 10. | Junior Subordinated Debt/Trust Preferred Securities |
At June 30, 2007, the Company held junior subordinated debentures issued to capital trusts commonly known as "Trust Preferred securities.” The debt instrument was issued by the Company’s wholly-owned special purpose trust entity, USB Capital Trust I on July 25, 2001 in the amount of $15,000,000 with a thirty-year maturity, interest benchmarked at the 6-month-LIBOR rate (re-priced in January and July each year) plus 3.75%. The Company had the ability to redeem the debentures at its option. The prepayment provisions of the instrument allowed repayment after five years (July 25, 2006) with certain prepayment penalties. On July 25, 2007, the Company redeemed the $15.0 million in subordinated debentures plus accrued interest of $690,000 and a 6.15% prepayment penalty totaling $922,500. Concurrently, the Trust Preferred securities issued by Capital Trust I were redeemed. The prepayment penalty of $922,500 had previously been a component of the fair value adjustment for the junior subordinated debt at the initial adoption of SFAS No. 159, and as a result was recorded through retained earnings effective January 1, 2007.
During July 2007, the Company formed USB Capital Trust II, a wholly-owned special purpose entity, for the purpose of issuing Trust Preferred Securities. Like USB Capital Trust I formed in July 2001, USB Capital Trust II is a Variable Interest Entity (VIE) and will be considered a deconsolidated entity pursuant to FIN 46. On July 23, 2007 USB Capital Trust II issued $15 million in Trust Preferred securities. The securities have a thirty-year maturity and bear a floating rate of interest (repricing quarterly) of 1.29% over the three-month LIBOR rate (initial coupon rate of 6.65%). Interest will be paid quarterly. Concurrent with the issuance of the Trust Preferred securities, USB Capital Trust II used the proceeds of the Trust Preferred securities offering to purchase a like amount of junior subordinated debentures of the Company. The Company will pay interest on the junior subordinated debentures to USB Capital Trust II, which represents the sole source of dividend distributions to the holders of the Trust Preferred securities. The Company may redeem the junior subordinated debentures at anytime before October 2008 at a redemption price of 103.3, and thereafter each October as follows: 2008 at 102.64, 2009 at 101.98, 2010 at 101.32, 2011 at 100.66, and at par anytime after October 2012.
As with the previous junior subordinated securities issued under USB Capital Trust I, the Company elected the fair value measurement option for all the Company’s new junior subordinated debentures issued under USB Capital Trust II. During the year ended December 31, 2007, the Company recorded pre-tax gains of $2.5 million pursuant to SFAS No. 159 as measured under fair value measurement guidelines of SFAS No. 157. The initial gain of $2.1 million realized on USB Capital Trust II during the third quarter resulted from an overall deterioration of the credit markets during the third quarter of 2007 which increased pricing spreads from base rates on similar debt instruments. The Company recorded an additional gain on the junior subordinated debt of $270,000 during the fourth quarter of 2007 bring the year-to-date gain on the junior subordinated debt issued by USB Capital Trust II to $2.4 million.
During each quarter for the year ended December 31, 2008 the Company performed a fair value measurement analysis on its junior subordinated debt pursuant to SFAS No. 157 using a valuation model approach that had been utilized in previous periods because of the absences of quoted market prices. Because the trust preferred markets became effectively inactive during the first quarter of 2008 due to increasing credit concerns in the capital markets, management used unobservable pricing spreads to 3-month LIBOR in the fair value determination of its junior subordinated debt. Management utilized a similar market spread from 3-month LIBOR to that used for the fourth quarter of 2007 when observable data were more available. Management believes this market spread remained indicative of those used by market participants throughout 2008, although for purposes of the fair value analysis performed for September 30, 2008 and December 31, 2008, that spread was increased by 20 basis points. The Company believes that when financial markets again normalize, market credit spreads will be slightly higher than they were prior to 2007, although it is difficult to determine by how much at this time.
The fair value calculation performed at December 31, 2008 resulted in a pretax gain adjustment of $899,000 for the quarter ended December 31, 2008, and a cumulative pretax gain adjustment $1.4 million for the year ended December 31, 2008. The cumulative gain adjustment made during the fourth quarter of 2008 is primarily the result of a 261 basis point decline in the 3-month LIBOR base rate between September 30, 2008 and December 31, 2008. At December 31, 2008, the total cumulative fair value gain recorded on the balance sheet for was $3.7 million. Fair value gains and losses subsequent to initial adoption of SFAS No. 159 are reflected as a component of noninterest income.
The tax effects of significant items comprising the Company’s net deferred tax assets (liabilities) are as follows:
| | | December 31, | |
| (In thousands) | | 2008 | | | 2007 | |
| Deferred tax assets: | | | | | | |
| Credit losses not currently deductible | | $ | 6,088 | | | $ | 4,646 | |
| State franchise tax | | | 355 | | | | 525 | |
| Deferred compensation | | | 1,430 | | | | 1,249 | |
| Net operating losses | | | 1,147 | | | | 1,830 | |
| Startup/organizational costs | | | 0 | | | | 113 | |
| Depreciation | | | 103 | | | | — | |
| Accrued reserves | | | 93 | | | | 133 | |
| Write-down on other real estate owned | | | 379 | | | | 15 | |
| Capitalized OREO expenses | | | 349 | | | | 0 | |
| Unrealized gain on interest rate swap | | | 0 | | | | 39 | |
| Unrealized loss on AFS securities | | | 1,954 | | | | 44 | |
| Amortization of premium on time deposits | | | 28 | | | | 46 | |
| Other | | | 76 | | | | 95 | |
| Total deferred tax assets | | | 12,002 | | | | 8,735 | |
| Deferred tax liabilities: | | | | | | | | |
| Depreciation | | | — | | | | (24 | ) |
| FHLB dividend | | | (243 | ) | | | (204 | ) |
| Loss on limited partnership investment | | | (1,814 | ) | | | (1,590 | ) |
| Amortization of core deposit intangible | | | (734 | ) | | | (1,249 | ) |
| Deferred gain SFAS No. 159 – fair value option | | | (1,538 | ) | | | (998 | ) |
| Fair value adjustments for purchase accounting | | | (120 | ) | | | — | |
| Prepaid expenses | | | (415 | ) | | | (369 | ) |
| Total deferred tax liabilities | | | (4,864 | ) | | | (4,434 | ) |
| Net deferred tax assets | | $ | 7,138 | | | $ | 4,301 | |
The Company periodically evaluates its deferred tax assets to determine whether a valuation allowance is required based upon a determination that some or all of the deferred assets may not be ultimately realized. The Company has concluded that it is more likely than not that the deferred tax assets will be recognized in the normal course of business, therefore no valuation allowance is considered necessary at December 31, 2008 and 2007.
Taxes on income for the years ended December 31, consist of the following:
| (In thousands) | | | | | | | | | |
| | | Federal | | | State | | | Total | |
| 2008: | | | | | | | | | | | | |
| Current | | $ | 1,461 | | | $ | 1,172 | | | $ | 2,633 | |
| Deferred | | | (400 | ) | | | (628 | ) | | | (1,028 | ) |
| | | $ | 1,061 | | | $ | 544 | | | $ | 1,605 | |
| 2007: | | | | | | | | | | | | |
| Current | | $ | 3,640 | | | $ | 1,507 | | | $ | 5,147 | |
| Deferred | | | 1,091 | | | | 323 | | | | 1,414 | |
| | | $ | 4,731 | | | $ | 1,830 | | | $ | 6,561 | |
| 2006: | | | | | | | | | | | | |
| Current | | $ | 6,284 | | | $ | 2,133 | | | $ | 8,417 | |
| Deferred | | | (390 | ) | | | 8 | | | | (382 | ) |
| | | $ | 5,894 | | | $ | 2,141 | | | $ | 8,035 | |
A reconciliation of the statutory federal income tax rate to the effective income tax rate is as follows:
| | | Years Ended December 31, | |
| | | 2008 | | | 2007 | | | 2006 | |
| Statutory federal income tax rate | | | 34.0 | % | | | 35.0 | % | | | 35.0 | % |
| State franchise tax, net of federal income tax benefit | | | 7.1 | | | | 7.0 | | | | 7.0 | |
| Tax exempt interest income | | | (0.4 | ) | | | (0.2 | ) | | | (0.2 | ) |
| Low Income Housing – federal credits | | | (9.3 | ) | | | (3.1 | ) | | | (2.6 | ) |
| Other | | | (3.1 | ) | | | (1.9 | ) | | | (1.4 | ) |
| | | | 28.3 | % | | | 36.8 | % | | | 37.8 | % |
At December 31, 2008 the Company has remaining federal net operating loss carry-forwards totaling $2.3 million which expire between 2023 and 2027, and remaining state net operating loss carry-forwards totaling $5.3 million which expire between 2015 and 2019.
The Company adopted the provisions of FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (FIN48), on January 1, 2007. FIN 48 clarifies SFAS No. 109, “Accounting for Income Taxes,” to indicate a criterion that an individual tax position would have to meet for some or all of the income tax benefit to be recognized in a taxable entity’s financial statements. Under the guidelines of FIN48, an entity should recognize the financial statement benefit of a tax position if it determines that it is more likely than not that the position will be sustained on examination. The term, “more likely than not”, means a likelihood of more than 50 percent.” In assessing whether the more-likely-than-not criterion is met, the entity should assume that the tax position will be reviewed by the applicable taxing authority and all available information is known to the taxing authority.
The Company and a subsidiary file income tax returns in the U.S federal jurisdiction, and several states within the U.S. There are no filings in foreign jurisdictions. The Company is not currently aware of any tax jurisdictions where the Company or any subsidiary is subject examination by state or local taxing authorities before 2001, or by federal taxing authorities before 2005. The Internal Revenue Service (IRS) has not examined the Company’s or any subsidiaries federal tax returns since before 2001, and the Company currently is not aware of any examination planned or contemplated by the IRS. The California Franchise Tax Board (FTB) concluded an audit of the Company’s 2004 state tax return during the fourth quarter of 2007, resulting in a disallowance of approximately $19,000 related to Enterprise Zone loan interest deductions taken during 2004. The $19,000 was recorded as a component of tax expense for the year ended December 31, 2007.
During the second quarter of 2006, the FTB issued the Company a letter of proposed adjustments to, and assessments for, (as a result of examination of the tax years 2001 and 2002) certain tax benefits taken by the REIT during 2002. The Company continues to review the information available from the FTB and its financial advisors and believes that the Company's position has merit. The Company is pursing its tax claims and will defend its use of these entities and transactions. The Company will continue to assert its administrative protest and appeal rights pending the outcome of litigation by another taxpayer presently in process on the REIT issue in the Los Angeles Superior Court (City National v. Franchise Tax Board).
The Company reviewed its REIT tax position as of January 1, 2007 (adoption date) and again during subsequent quarter during 2007 in light of the adoption of FIN48. The Bank, with guidance from advisors believes that the case has merit with regard to points of law, and that the tax law at the time allowed for the deduction of the consent dividend. However, the Bank, with the concurrence of advisors, cannot conclude that it is “more than likely” (as defined in FIN48) that the Bank will prevail in its case with the FTB. As a result of the implementation of FIN48, the Company recognized approximately a $1.3 million increase in the liability for unrecognized tax benefits (included in other liabilities), which was accounted for as a reduction to the January 1, 2007 balance of retained earnings. The adjustment provided at adoption included penalties proposed by the FTB of $181,000 and interest totaling $210,000. During both the years ended December 31, 2008 and 2007, the Company recorded annually an additional $87,000 in interest liability pursuant to the provisions of FIN48. The Company had approximately $566,000 accrued for the payment of interest and penalties at December 31, 2008. Subsequent to the initial adoption of FIN48, it is the Company’s policy to recognize interest expense related to unrecognized tax benefits, and penalties, as a component tax expense. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in 000’s):
| Balance at January 1, 2008 | | $ | 1,385 | |
| Additions for tax provisions of prior years | | | 87 | |
| Balance at December 31, 2008 | | $ | 1,472 | |
| 12. | Stock Options and Stock Based Compensation |
Options have been granted to officers and key employees at an exercise price equal to estimated fair value at the date of grant as determined by the Board of Directors. All options granted are service awards, and as such are based solely upon fulfilling a requisite service period (the vesting period). In May 2005, the Company’s shareholders approved the adoption of the United Security Bancshares 2005 Stock Option Plan (2005 Plan). At the same time, all previous plans, including the 1995 Plan, were terminated. The 2005 Plan provides for the granting of up to 500,000 shares (adjusted for the 2-for-1 stock split effective May 2006) of authorized and unissued shares of common stock at option prices per share which must not be less than 100% of the fair market value per share at the time each option is granted. The 2005 Plan further provides that the maximum aggregate number of shares that may be issued as incentive stock options under the 2005 Plan is 500,000 (as adjusted for stock split).
The options granted (incentive stock options for employees and non-qualified stock options for Directors) have an exercise price at the prevailing market price on the date of grant under the 1995 or 2005 Stock Option Plans. The options granted under both the 1995 and 2005 Stock Option Plans are exercisable 20% each year commencing one year after the date of grant and expire ten years after the date of grant. Pursuant to the adoption of the 2005 Stock Option Plan, there are no remaining shares reserved under the 1995 Stock Option Plan.
The number of shares granted remaining under the 1995 Plan was 16,322 shares (14,282 exercisable) as of December 31, 2008. Under the 2005 Plan, 159,646 shares granted shares remain (146,385 incentive stock options and 13,261 nonqualified stock options) as of December 31, 2008, of which 75,895 are vested.
Options outstanding, exercisable, exercised and forfeited are as follows:
| | | | | | Weighted | | | | | | Weighted | |
| | | 2005 | | | Average | | | 1995 | | | Average | |
| | | Plan | | | Exercise Price | | | Plan | | | Exercise Price | |
| Options outstanding January 1, 2006 | | | 70,000 | | | $ | 14.47 | | | | 172,000 | | | $ | 7.11 | |
| Granted during the year | | | 103,500 | | | $ | 18.91 | | | | — | | | | — | |
| Exercised during the year | | | (2,000 | ) | | $ | 12.65 | | | | (46,000 | ) | | $ | 6.73 | |
| Options outstanding December 31, 2006 | | | 171,500 | | | $ | 17.05 | | | | 126,000 | | | $ | 7.25 | |
| Granted during the year | | | 5,000 | | | $ | 20.24 | | | | — | | | | — | |
| Exercised during the year | | | — | | | | — | | | | (90,000 | ) | | $ | 5.67 | |
| Options outstanding December 31, 2007 | | | 176,500 | | | $ | 17.14 | | | | 36,000 | | | $ | 11.21 | |
| Granted during the year | | | — | | | | — | | | | — | | | | — | |
| Exercised during the year | | | — | | | | — | | | | (8,000 | ) | | $ | 8.75 | |
| Forfeited during the year | | | (20,000 | ) | | $ | 22.54 | | | | (12,000 | ) | | $ | 11.53 | |
| Effects of common stock dividend | | | 3,145 | | | $ | (0.31 | ) | | | 322 | | | $ | (0.25 | ) |
| Options outstanding December 31, 2008 | | | 159,645 | | | $ | 16.13 | | | | 16,322 | | | $ | 11.96 | |
Included in total outstanding options at December 31, 2008, are 14,282 exercisable shares under the 1995 plan, at a weighted average price of $11.96, and 75,895 exercisable shares under the 2005 plan, at a weighted average price of $15.72. Included in total outstanding options at December 31, 2007, are 24,000 exercisable shares under the 1995 plan, at a weighted average price of $10.74, and 46,700 exercisable shares under the 2005 plan, at a weighted average price of $16.34. Included in total outstanding options at December 31, 2006, are 108,000 exercisable shares under the 1995 plan, at a weighted average price of $6.43, and 12,000 exercisable shares under the 2005 plan, at a weighted average price of $14.44.
Additional information regarding options as of December 31, 2008 is as follows:
| Options Outstanding | | | Options Exercisable | |
| | | | | | Weighted Avg | | | | | | | | | | |
| Range of | | Number | | | Remaining | | | Weighted Avg | | | Number | | | Weighted Avg | |
| Exercise Prices | | Outstanding | | | Contract Life (yrs) | | | Exercise Price | | | Exercisable | | | Exercise Price | |
| $11.96 to $12.40 | | | 24,482 | | | | 6.3 | | | $ | 12.11 | | | | 18,362 | | | $ | 12.06 | |
| $14.15 to $17.74 | | | 120,372 | | | | 6.8 | | | $ | 15.41 | | | | 60,390 | | | $ | 18.61 | |
| $18.99 to $22.09 | | | 31,113 | | | | 7.4 | | | $ | 19.89 | | | | 11,425 | | | $ | 19.90 | |
| Total | | | 175,967 | | | | | | | | | | | | 90,177 | | | | | |
Included in salaries and employee benefits for the years ended December 31, 2008, 2007 and 2006 is $110,000, $187,000 and $248,000 of share-based compensation, respectively. The related tax benefit on share-based compensation recorded in the provision for income taxes was not material to either year.
As of December 31, 2008, 2007 and 2006, there was $81,000, $223,500 and $388,000, respectively, of total unrecognized compensation expense related to nonvested stock options. This cost is expected to be recognized over a weighted average period of approximately 1.0 years. The Company received $70,000, $510,000 and $335,000 in cash proceeds on options exercised during the years ended December 31, 2008, 2007 and 2006, respectively. No tax benefits were realized on stock options exercised during the years ended December 31, 2008 and 2007, because all options exercised during the period were incentive stock options. Tax benefits realized on options exercised during the year ended December 31, 2006 totaled $218,000.
| | | Year Ended | | | Year Ended | |
| | | December 31, 2008 | | | December 31, 2007 | |
| Weighted average grant-date fair value of stock options granted | | | n/a | | | $ | 4.51 | |
| Total fair value of stock options vested | | $ | 173,393 | | | $ | 167,028 | |
| Total intrinsic value of stock options exercised | | $ | 55,000 | | | $ | 1,517,000 | |
The Bank determines fair value at grant date using the Black-Scholes-Merton pricing model that takes into account the stock price at the grant date, the exercise price, the expected life of the option, the volatility of the underlying stock and the expected dividend yield and the risk-free interest rate over the expected life of the option.
The weighted average assumptions used in the pricing model are noted in the table below. The expected term of options granted is derived using the simplified method, which is based upon the average period between vesting term and expiration term of the options. The risk free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of the grant. Expected volatility is based on the historical volatility of the Bank's stock over a period commensurate with the expected term of the options. The Company believes that historical volatility is indicative of expectations about its future volatility over the expected term of the options.
For options valued in accordance with FAS 123R, the Bank expenses the fair value of the option on a straight-line basis over the vesting period for each separately vesting portion of the award. The Bank estimates forfeitures and only recognizes expense for those shares expected to vest. Based upon historical evidence, the Company has determined that because options are granted to a limited number of key employees rather than a broad segment of the employee base, expected forfeitures, if any, are not material.
| | | Year Ended | |
| | | December 31, 2008 | | | December 31, 2007 | |
| Risk Free Interest Rate | | | — | | | | 4.53% | |
| Expected Dividend Yield | | | — | | | | 2.47% | |
| Expected Life in Years | | | — | | | 6.50 Years | |
| Expected Price Volatility | | | — | | | | 20.63% | |
The Black-Scholes-Merton option valuation model requires the input of highly subjective assumptions, including the expected life of the stock based award and stock price volatility. The assumptions listed above represent management's best estimates, but these estimates involve inherent uncertainties and the application of management judgment. As a result, if other assumptions had been used, the Bank's recorded stock-based compensation expense could have been materially different from that previously reported in proforma disclosures. In addition, the Bank is required to estimate the expected forfeiture rate and only recognize expense for those shares expected to vest. If the Bank's actual forfeiture rate is materially different from the estimate, the share-based compensation expense could be materially different.
| 13. | Employee Benefit Plans |
Employee Stock Ownership Plan
The Company has an Employee Stock Ownership Plan and Trust, (the “ESOP”), designed to enable eligible employees to acquire shares of common stock. ESOP eligibility is based upon length of service requirements. The Bank contributes cash to the ESOP in an amount determined at the discretion of the Board of Directors. The trustee of the ESOP uses such contribution to purchase shares of common stock currently outstanding, or to repay debt on the leveraged portion of the ESOP, if applicable. The shares of stock purchased by the trustee are then allocated to the accounts of the employees participating in the ESOP on the basis of total relative compensation. Employer contributions vest over a period of six years.
ESOP compensation expense totaled $264,000, $501,000, and $409,000 for the years ended December 31, 2008, 2007, and 2006 respectively.
Allocated, committed-to-be-released, and unallocated ESOP shares as of December 31, 2008, 2007 and 2006 were as follows (shares adjusted for 2-for-1 stock split of May 2006):
| | | 2008 | | | 2007 | | | 2006 | |
| Allocated | | | 421,049 | | | | 402,988 | | | | 375,639 | |
| Committed-to-be-released | | | 0 | | | | 0 | | | | 0 | |
| Unallocated | | | 0 | | | | 0 | | | | 0 | |
| Total ESOP shares | | | 421,049 | | | | 402,988 | | | | 375,639 | |
| Fair value of unreleased shares | | | N/A | | | | N/A | | | | N/A | |
401K Plan
The Company has a Cash or Deferred 401(k) Stock Ownership Plan (the “401(k) Plan”) organized under Section 401(k) of the Code. All employees of the Company are initially eligible to participate in the 401(k) Plan upon the first day of the month after date of hire. Under the terms of the plan, the participants may elect to make contributions to the 401(k) Plan as determined by the Board of Directors. Participants are automatically vested 100% in all employee contributions. Participants may direct the investment of their contributions to the 401(k) Plan in any of several authorized investment vehicles. The Company contributes funds to the Plan up to 5% of the employees’ eligible annual compensation. Company contributions are subject to certain vesting requirements over a period of six years. Contributions made by the Company are invested in Company stock. During 2008, 2007 and 2006, the Company contributed a total of $137,000, $286,000, and $242,000, respectively, to the Deferral Plan.
Salary Continuation Plan
The Company has an unfunded, non-qualified Salary Continuation Plan for senior executive officers and certain other key officers of the Company, which provides additional compensation benefits upon retirement for a period of 15 years. Future compensation under the Plan is earned by the employees for services rendered through retirement and vests over a period of 12 to 15 years. The Company accrues for the salary continuation liability based on anticipated years of service and vesting schedules provided under the Plan. The Company’s current benefit liability is determined based upon vesting and the present value of the benefits at a corresponding discount rate. The discount rate used is an equivalent rate for high-quality investment-grade bonds with lives matching those of the service periods remaining for the salary continuation contracts, which averages approximately 20 years. At December 31, 2008 and 2007, $3.3 million and $3.0 million, respectively, had been accrued to date, based on a discounted cash flow using an average discount rate of 6.10% and 6.40%, respectively, and is included in other liabilities. In connection with the implementation of the Salary Continuation Plans, the Company purchased single premium universal life insurance policies on the life of each of the key employees covered under the Plan. The Company is the owner and beneficiary of these insurance policies. The cash surrender value of the policies was $3.8 million and $3.7 million December 31, 2008 and 2007, respectively. Although the Plan is unfunded, the Company intends to utilize the proceeds of such policies to settle the Plan obligations. Under Internal Revenue Service regulations, the life insurance policies are the property of the Company and are available to satisfy the Company's general creditors.
Effective December 31, 2006, the Company adopted Statement of Financial Accounting Standards No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans (“SFAS No. 158”). SFAS No. 158 amends SFAS No. 87 and SFAS No. 106, which the Bank previously has followed for accounting for its salary continuation plan.
SFAS No. 158 amends previous applicable accounting statements and requires companies to better disclose, among other things, the funded status of benefit plans, and to recognize as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that arise during the period but are not recognized as components of net periodic benefit cost pursuant to FASB Statement No. 87, Employers’ Accounting for Pensions, or No. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions. Amounts recognized in accumulated other comprehensive income, including the gains or losses, prior service costs or credits, and the transition asset or obligation remaining from the initial application of Statements 87 and 106, are adjusted as they are subsequently recognized as components of net periodic benefit cost pursuant to the recognition and amortization provisions of those Statements.
In addition to expanded disclosure requirements under the Statement, the Company is required to recognize in accumulated other comprehensive income, the amounts that have not yet been recognized as components of net periodic benefit costs. These unrecognized costs arise from of changes in estimated interest rates used in the calculation of net liabilities under the plan. Under SFAS No. 87 and SFAS No. 106, these differences were previously recognized over the remaining required service period of the salary continuation contracts. SFAS No. 158 requires the Company to record those unrecognized periodic benefit costs from previous period as a component of accumulated other comprehensive income.
As of December 31, 2008 and 2007, the Company had approximately $13,000 in excess net periodic benefit costs and $142,000 in unrecognized net periodic benefit costs, respectively, arising from changes in interest rates used in calculating the current post-retirement liability required under the plan. This amount represents the difference between the plan liabilities calculated under net present value calculations, and the net plan liabilities actually recorded on the Company’s books at December 31, 2008 and 2007. Pursuant to the adoption of SFAS No. 158, the Company recorded $169,000 (net of tax of $112,000), as a component of other comprehensive income at December 31, 2006. The average remaining life of the service terms of the Salary Continuation contracts to which the unrecognized service costs related at the time of adoption, was approximately two years. During the year ended December 31, 2008, approximately $142,000 of the unrecognized prior service cost was recognized in earnings as additional salary expense, reflected as an adjustment to accumulated other comprehensive income.
Salary continuation expense is included in salaries and benefits expense, and totaled $551,000, $504,000, and $448,000 for the years ended December 31, 2008, 2007, and 2006, respectively.
Officer Supplemental Life Insurance Plan
During 2004, the Company purchased single premium Bank-owned life insurance policies (BOLI) on certain officers with a portion of the death benefits available to the officers’ beneficiaries. The single premium paid at policy commencement of the BOLI in 2004 totaled $9.0 million. Additional BOLI policies totaling $227,000 and $579,000 were purchased during 2006 and 2005, respectively. The BOLI’s initial net cash surrender value is equivalent to the premium paid, and it adds income through non-taxable increases in its cash surrender value, net of the cost of insurance, plus any death benefits ultimately received by the Company. The cash surrender value of these insurance policies totaled $10.6 million and $10.2 million at December 31, 2008 and December 31, 2007, and is included on the consolidated balance sheet in cash surrender value of life insurance. Income on these policies, net of expense, totaled approximately $249,000, $408,000, and $400,000 for the years ended December 31, 2008, 2007 and 2006, respectively.
| 14. | Commitments and Contingent Liabilities |
Lease Commitments: The Company leases land and premises for its branch banking offices and administration facilities. The initial terms of these leases expire at various dates through 2019. Under the provisions of most of these leases, the Company has the option to extend the leases beyond their original terms at rental rates adjusted for changes reported in certain economic indices or as reflected by market conditions. The total expense on land and premises leased under operating leases was $864,000, $877,000, and $407,000 during 2008, 2007, and 2006, respectively. Total rent expense for the years ended December 31, 2008 and 2007 included approximately $27,000 and $165,000, respectively, related to adjustments made under SFAS No. 13, “Accounting for Leases”.
During the fourth quarter of 2007 the Company reviewed accounting methods for recording rent expense under operating leases pursuant to SFAS No. 13 “Accounting for Leases”. The Company had previously recognized periodic rent expense as those contractual rent payments became payable to the lessor, rather than on a straight-line basis throughout the life of the lease. The difference in methodology was not previously considered material, but as the Company has grown, it was determined that adjustments should be made to properly comply with SFAS No. 13. The expense adjustment to record the difference between the contractual rental payment amounts and straight-line expense over the lease terms as applicable under SFAS No. 13 totaled $165,000 ($95,000 net of tax, and less than $0.01 per share) and was recorded as a liability as of December 31, 2007. Adjustments made pursuant to SAFS No. 13 during 2008 increased the liability to $191,000 at December 31, 2008. This timing difference will reverse beginning in 2009 and will decline over the remaining term of the Company’s leases through 2019.
Future minimum rental commitments under existing non-cancelable leases as of December 31, 2008 are as follows:
| (In thousands): | | | |
| 2009 | | $ | 759 | |
| 2010 | | | 713 | |
| 2011 | | | 389 | |
| 2012 | | | 392 | |
| 2013 | | | 397 | |
| Thereafter | | | 1,007 | |
| | | $ | 3,657 | |
Financial Instruments with Off-Balance Sheet Risk: The Company is party to financial instruments with off-balance sheet risk which arise in the normal course of business. These instruments may contain elements of credit risk, interest rate risk and liquidity risk, and include commitments to extend credit and standby letters of credit. The credit risk associated with these instruments is essentially the same as that involved in extending credit to customers and is represented by the contractual amount indicated in the table below:
| | | Contractual amount – December 31, | |
| (in thousands) | | 2008 | | | 2007 | |
| Commitments to extend credit | | $ | 112,278 | | | $ | 196,258 | |
| Standby letters of credit | | | 7,119 | | | | 6,726 | |
Commitments to extend credit are agreements to lend to a customer, as long as there is no violation of any condition established in the contract. Substantially all of these commitments are at floating interest rates based on the Prime rate, and most have fixed expiration dates. The Company evaluates each customer's creditworthiness on a case-by-case basis, and the amount of collateral obtained, if deemed necessary, is based on management's credit evaluation. Collateral held varies but includes accounts receivable, inventory, leases, property, plant and equipment, residential real estate and income-producing properties. Many of the commitments are expected to expire without being drawn upon and, as a result, the total commitment amounts do not necessarily represent future cash requirements of the Company.
Standby letters of credit are generally unsecured and are issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers. The Company’s letters of credit are short-term guarantees and have terms from less than one month to approximately 2.5 years. At December 31, 2008, the maximum potential amount of future undiscounted payments the Company could be required to make under outstanding standby letters of credit totaled $7.1 million.
| 15. | Fair Value Measurements and Disclosure |
The following summary disclosures are made in accordance with the provisions of Statement of Financial Accounting Standards No. 107, “Disclosures About Fair Value of Financial Instruments,” which requires the disclosure of fair value information about both on- and off- balance sheet financial instruments where it is practicable to estimate that value.
| | | December 31, 2008 | | | December 31, 2007 | |
| | | | | | Estimated | | | | | | Estimated | |
| | | Carrying | | | Fair | | | Carrying | | | Fair | |
| (In thousands) | | Amount | | | Value | | | Amount | | | Value | |
| Financial Assets: | | | | | | | | | | | | |
| Cash and cash equivalents | | $ | 19,426 | | | $ | 19,426 | | | $ | 25,300 | | | $ | 25,300 | |
| Interest-bearing deposits | | | 20,431 | | | | 20,490 | | | | 2,909 | | | | 2,918 | |
| Investment securities | | | 92,749 | | | | 92,749 | | | | 89,415 | | | | 89,415 | |
| Loans, net | | | 548,742 | | | | 539,540 | | | | 596,481 | | | | 594,054 | |
| Bank-owned life insurance | | | 14,460 | | | | 14,460 | | | | 13,852 | | | | 13,852 | |
| Investment in bank stock | | | 121 | | | | 121 | | | | 372 | | | | 372 | |
| Interest rate swap contracts | | | 0 | | | | 0 | | | | (12 | ) | | | (12 | ) |
| Financial Liabilities: | | | | | | | | | | | | | | | | |
| Deposits | | | 508,486 | | | | 507,847 | | | | 634,617 | | | | 633,408 | |
| Borrowings | | | 155,045 | | | | 154,689 | | | | 32,280 | | | | 32,162 | |
| Junior Subordinated Debt | | | 11,926 | | | | 11,926 | | | | 13,341 | | | | 13,341 | |
| Commitments to extend credit | | | — | | | | — | | | | — | | | | — | |
| Standby letters of credit | | | — | | | | — | | | | — | | | | — | |
Effective January 1, 2007, the Company adopted SFAS 157, “Fair Value Measurements”, concurrent with its early adoption of SFAS No. 159. SFAS No. 157 clarifies the definition of fair value, describes methods generally used to appropriately measure fair value in accordance with generally accepted accounting principles and expands fair value disclosure requirements. Fair value is defined in SFAS No. 157 as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The statement applies whenever other accounting pronouncements require or permit fair value measurements.
The fair value hierarchy under SFAS No. 157 prioritizes the inputs to valuation techniques used to measure fair value into three broad levels (Level 1, Level 2, and Level 3). Level 1 inputs are unadjusted quoted prices in active markets (as defined) for identical assets or liabilities that the Company has the ability to access at the measurement date. Level 2 inputs are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. Level 3 inputs are unobservable inputs for the asset or liability, and reflect the Company’s own assumptions about the assumptions that market participants would use in pricing the asset or liability (including assumptions about risk) in a principal market.
The Company performs fair value measurements on certain assets and liabilities as the result of the application of accounting guidelines and pronouncements that were relevant prior to the adoption of SFAS No. 157. Some fair value measurements, such as for available-for-sale securities, junior subordinated debt, impaired loans that are collateral dependent, and interest rate swaps, are performed on a recurring basis, while others, such as impairment of goodwill and other intangibles, are performed on a nonrecurring basis.
The following tables summarize the Company’s assets and liabilities that were measured at fair value on a recurring basis during the year ended December 31, 2008 (in 000’s):
| | | December 31, | | | Quoted Prices in Active Mar- kets for Identi- cal Assets | | | Significant Other Observ- able Inputs | | | Significant Un- observable In- puts | |
| Description of Assets | | 2008 | | | (Level 1) | | | (Level 2) | | | (Level 3) | |
| AFS securities | | $ | 92,749 | | | $ | 13,017 | | | $ | 66,932 | | | $ | 12,800 | |
| Investment in bank stock | | | 121 | | | | 121 | | | | | | | | | |
| Purchased intangible asset (1) | | | 206 | | | | | | | | | | | $ | 206 | |
| Impaired loans | | | 22,452 | | | | | | | | 4,602 | | | $ | 17,850 | |
| Core deposit intangible (1) | | | 1,283 | | | | | | | | | | | $ | 1,283 | |
| Total | | $ | 116,811 | | | $ | 13,138 | | | $ | 71,534 | | | $ | 32,139 | |
| (1) Nonrecurring items | | | | | | | | | | | | | | | | |
| | | December 31, | | | Quoted Prices in Active Mar- kets for Identi- cal Assets | | | Significant Other Observ- able Inputs | | | Significant Un- observable In- puts | |
| Description of Liabilities | | 2008 | | | (Level 1) | | | (Level 2) | | | (Level 3) | |
| Junior subordinated debt | | $ | 11,926 | | | | | | | | | $ | 11,926 | |
| Total | | $ | 11,926 | | | $ | 0 | | | $ | 0 | | | $ | 11,926 | |
Upon adoption of SFAS No. 159 on January 1, 2007, the Company elected the fair value measurement option for all the Company’s pre-existing junior subordinated debentures, and subsequently for new junior subordinated debentures issued during July 2007 under USB Capital Trust II. The fair value of the debentures was determined based upon discounted cash flows utilizing observable market rates and credit characteristics for similar instruments. In its analysis, the Company used characteristics that distinguish market participants generally use, and considered factors specific to (a) the liability, (b) the principal (or most advantageous) market for the liability, and (c) market participants with whom the reporting entity would transact in that market. The adjustment for fair value at adoption was recorded as a cumulative-effect adjustment to the opening balance of retained earnings at January 1, 2007. Fair value adjustments subsequent to adoption were recorded in current earnings.
The following tables summarize the Company’s assets and liabilities that were measured at fair value on a recurring basis as of December 31, 2007 (in 000’s):
| | | December | | | Quoted Prices in Active��Mar- kets for Identical Assets | | | Significant Other Observ- able Inputs | | | Significant Un- observable In- puts | |
| Description of Assets | | | 31, 2007 | | | (Level 1) | | | (Level 2) | | | (Level 3) | |
| AFS Securities | | $ | 89,415 | | | $ | 13,326 | | | $ | 76,089 | | | | |
| Interest Rate Swap | | | (12 | ) | | | | | | $ | (12 | ) | | | |
| Impaired Loans (non-recurring) | | | 6,298 | | | | | | | | 4,185 | | | $ | 2,113 | |
| Total | | $ | 95,701 | | | $ | 13,326 | | | $ | 80,262 | | | $ | 2,113 | |
| | | December | | | Quoted Prices in Active Mar- kets for Identical Assets | | | Significant Other Observ- able Inputs | | | Significant Un- observable In- puts | |
| Description of Liabilities | | | 31, 2007 | | | (Level 1) | | | (Level 2) | | | (Level 3) | |
| Junior subordinated debt | | $ | 13,341 | | | | | | $ | 13,341 | | | | |
| Total | | $ | 13,341 | | | $ | 0 | | | $ | 13,341 | | | $ | 0 | |
The following tables summarize the Company’s assets and liabilities that were measured at fair value on a nonrecurring basis during the year ended December 31, 2007 (in 000’s):
| | | (in 000’s) Dec 31, | | | Quoted Prices in Active Mar- kets for Identi- cal Assets | | | Significant Other Observ- able Inputs | | | Significant Un- observable In- puts | |
| Description of Assets | | 2007 | | | (Level 1) | | | (Level 2) | | | (Level 3) | |
| Business combination: | | | | | | | | | | | | |
| Securities – AFS | | $ | 7,414 | | | $ | 7,414 | | | | | | | | |
| Loans, net allowance for losses | | | 62,426 | | | | | | | | | | | $ | 62,426 | |
| Premises and Equipment | | | 729 | | | | | | | | | | | | 729 | |
| Goodwill | | | 8,790 | | | | | | | | | | | | 8,790 | |
| Other assets | | | 6,928 | | | | | | | | | | | | 6,928 | |
| Total assets | | $ | 86,287 | | | $ | 7,414 | | | $ | 0 | | | $ | 78,873 | |
| | | (in 000's) | | | Quoted Prices in Active Mar- kets for Identi- cal Assets | | | Significant Other Observ- able Inputs | | | Significant Un- observable In- puts | |
| Description of Liabilities | | Dec 31, 2007 | | | (Level 1) | | | (Level 2) | | | (Level 3) | |
Business combination: | | | | | | | | | | | | |
| Deposits (net CDI) | | $ | 66,600 | | | | | | | | | | | $ | 66,600 | |
| Other liabilities | | | 286 | | | | | | | | | | | | 286 | |
| Total liabilities | | $ | 66,886 | | | $ | 0 | | | $ | 0 | | | $ | 66,886 | |
The Company completed its merger with Legacy Bank in February 2007. The merger transaction was accounted for using the purchase accounting method, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Legacy Bank based on the fair value of those assets and liabilities. The allocations of purchase price based upon the fair value of assets acquired and liabilities assumed were finalized during the fourth quarter of 2007. The fair value measurements for Legacy’s loan portfolio included certain market rate assumptions on segmented portions of the loan portfolio with similar credit characteristics, and credit risk assumptions specific to the individual loans within that portfolio. Available-for sale securities were valued based upon open-market quotes obtained from third-party sources. Legacy’s deposits were valued based upon anticipated net present cash flows related to Legacy’s deposit base, and resulted in a core deposit intangible (CDI) adjustment of $3.0 million that is carried as an asset on the Company’s balance sheet. Assumptions used to determine the CDI included anticipated costs of, and revenues generated by, those deposits, as well as the estimated life of the deposit base. Other assets and liabilities generally consist of short-term items including cash, overnight investments, and accrued interest receivable or payable, and as such, it was determined that carrying value approximated fair value.
The following tables provide a reconciliation of assets and liabilities at fair value using significant unobservable inputs (Level 3) on both a recurring (impaired loans) and nonrecurring (business combination) basis during the period (in 000’s):
| | | 12/31/08 | | | 12/31/08 | | | 12/31/08 | | | 12/31/07 | | | 12/31/07 | |
| | | Impaired loans | | | CMO’s | | | Intangi- ble assets | | | Impaired loans | | | Business Combina- tions | |
Reconciliation of Assets: | | | | | | | | | | | | | | | | | | | | |
| Beginning balance | | $ | 2,211 | | | $ | 0 | | | $ | 0 | | | $ | 1,521 | | | $ | 0 | |
| Total gains or (losses) included in earnings (or changes in net assets) | | | (386 | ) | | | (4,951 | ) | | | (648 | ) | | | (203 | ) | | | 9,910 | |
| Transfers in and/or out of Level 3 | | | 16,025 | | | | 17,751 | | | | 2,137 | | | | 893 | | | | 68,748 | |
| Ending balance | | $ | 17,850 | | | $ | 12,800 | | | $ | 1,489 | | | $ | 2,211 | | | $ | 78,658 | |
| | | | | | | | | | | | | | | | | | | | | |
| The amount of total gains or (losses) for the period included in earnings (or changes in net assets) attributable to the change in unrealized gains or losses relating to assets still held at the reporting date | | $ | (3,168 | ) | | $ | (4,951 | ) | | $ | (648 | ) | | $ | (203 | ) | | $ | 9,910 | |
| | | 12/31/2008 | | | 12/31/2007 | |
| | | Junior Subordinated Debt | | | Business Combinations | |
Reconciliation of Liabilities: | | | | | | |
| Beginning balance | | $ | 0 | | | $ | 0 | |
| Total gains included in earnings (or changes in net assets) | | | (1,363 | ) | | | (3,215 | ) |
| Transfers in and/or out of Level 3 | | | 13,289 | | | | 69,600 | |
| Ending balance | | $ | 11,926 | | | $ | 66,385 | |
| | | | | | | | | |
| The amount of total gains for the period included in earnings (or changes in net assets) attributable to the change in unrealized gains or losses relating to liabilities still held at the reporting date | | $ | (1,363 | ) | | $ | (3,215 | ) |
The following methods and assumptions were used in estimating the fair values of financial instruments:
Cash and Cash Equivalents - The carrying amounts reported in the balance sheets for cash and cash equivalents approximate their estimated fair values.
Interest-bearing Deposits – Interest bearing deposits in other banks consist of fixed-rate certificates of deposits. Accordingly, fair value has been estimated based upon interest rates currently being offered on deposits with similar characteristics and maturities.
Investments – Available for sale securities are valued based upon open-market price quotes obtained from reputable third-party brokers that actively make a market in those securities. Market pricing is based upon specific CUSIP identification for each individual security. To the extent there are observable prices in the market, the mid-point of the bid/ask price is used to determine fair value of individual securities. If that data is not available for the last 30 days, a level 2-type matrix pricing approach based on comparable securities in the market is utilized. Level-2 pricing may include using a spread forward from the last observable trade or may use a proxy bond like a TBA mortgage to come up with a price for the security being valued. Changes in fair market value are recorded in other comprehensive income as the securities are available for sale. At December 31, 2008, the Company held three private-label collateralized mortgage obligations (CMO’s) with an amortized cost of $17.6 million and carrying value of $12.8 million. Fair value of these securities (as well as review for other-than-temporary impairment) was performed by a third-party securities broker specializing in CMO’s. Fair value was based upon estimated cash flows which included assumptions about future prepayments, default rates, and the impact of credit risk on this type of investment security. Although the pricing of the CMO’s has certain aspects of Level 2 pricing, many of the pricing inputs are based upon assumptions of future economic trends and as a result the Company considers this to be Level 3 pricing.
Loans - Fair values of variable rate loans, which reprice frequently and with no significant change in credit risk, are based on carrying values. Fair values for all other loans, except impaired loans, are estimated using discounted cash flows over their remaining maturities, using interest rates at which similar loans would currently be offered to borrowers with similar credit ratings and for the same remaining maturities.
Impaired Loans - Fair value measurements for impaired loans are performed pursuant to SFAS No. 114, and are based upon either collateral values supported by appraisals, or observed market prices. The change in fair value of impaired assets that were valued based upon level three inputs was approximately $338,000 and $690,000 for the years ended December 31, 2008 and 2007, respectively. This loss is not recorded directly as an adjustment to current earnings or comprehensive income, but rather as an adjustment component in determining the overall adequacy of the loan loss reserve. Such adjustments to the estimated fair value of impaired loans may result in increases or decreases to the provision for credit losses recorded in current earnings.
Bank-owned Life Insurance – Fair values of life insurance policies owned by the Company approximate the insurance contract’s cash surrender value.
Investments in Bank Stock – Investment in Bank equity securities is classified as available for sale and is valued based upon open-market price quotes obtained from an active stock exchange. Changes in fair market value are recorded in other comprehensive income.
Interest Rate Swaps - The Company records interest rate swap contracts at fair value on the balance sheet. The fair value of interest rate swap contracts is based on the discounted net present value of the swap using third party dealer quotes.
Deposits – In accordance with SFAS No. 107, fair values for transaction and savings accounts are equal to the respective amounts payable on demand at December 31, 2008 and 2007 (i.e., carrying amounts). The Company believes that the fair value of these deposits is clearly greater than that prescribed by SFAS No. 107. Fair values of fixed-maturity certificates of deposit were estimated using the rates currently offered for deposits with similar remaining maturities.
Borrowings - - Borrowings consist of federal funds sold, securities sold under agreements to repurchase, and other short-term borrowings. Fair values of borrowings were estimated using the rates currently offered for borrowings with similar remaining maturities.
Junior Subordinated Debt – The fair value of the junior subordinated debt was determined based upon a valuation discounted cash flows model utilizing observable market rates and credit characteristics for similar instruments. In its analysis, the Company used characteristics that distinguish market participants generally use, and considered factors specific to (a) the liability, (b) the principal (or most advantageous) market for the liability, and (c) market participants with whom the reporting entity would transact in that market. For the year ended December 31, 2008, management utilized a similar market spread from 3-month LIBOR to that used for the fourth quarter of 2007 when observable data were more available. The Company believes this adjustment is significant enough to the fair value determination of the junior subordinated debt as to make them Level 3 inputs as of March 31, 2008, June 30, 2008, September 30, 2008, and December 31, 2008. The junior subordinated debt was classified as Level 2 as of December 31, 2007.
Off-balance sheet Instruments - Off-balance sheet instruments consist of commitments to extend credit, standby letters of credit and derivative contracts. The contract amounts of commitments to extend credit and standby letters of credit are disclosed in Note 14. Fair values of commitments to extend credit are estimated using the interest rate currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present counterparties’ credit standing. There was no material difference between the contractual amount and the estimated value of commitments to extend credit at December 31, 2008 and 2007.
Fair values of standby letters of credit are based on fees currently charged for similar agreements. The fair value of commitments generally approximates the fees received from the customer for issuing such commitments. These fees are deferred and recognized over the term of the commitment, and are not material to the Company’s consolidated balance sheet and results of operations.
Capital Guidelines - The Company (on a consolidated basis) and the Bank are subject to various regulatory capital requirements adopted by the Board of Governors of the Federal Reserve System (“Board of Governors”). Failure to meet minimum capital requirements can initiate certain mandates and possible additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s consolidated financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the consolidated Company 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. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Prompt corrective action provisions are not applicable to bank holding companies.
Quantitative measures established by regulation to ensure capital adequacy require insured institutions to maintain a minimum leverage ratio of Tier 1 capital (the sum of common stockholders' equity, noncumulative perpetual preferred stock and minority interests in consolidated subsidiaries, minus intangible assets, identified losses and investments in certain subsidiaries, plus unrealized losses or minus unrealized gains on available for sale securities) to total assets. Institutions which have received the highest composite regulatory rating and which are not experiencing or anticipating significant growth are required to maintain a minimum leverage capital ratio of 3% of Tier 1 capital to total assets. All other institutions are required to maintain a minimum leverage capital ratio of at least 100 to 200 basis points above the 3% minimum requirement.
| | | | | | | | | | | | | | | To Be Well Capitalized Under | |
| | | | | | For Capital | | | Prompt Corrective | |
| | | Actual | | | Adequacy Purposes | | | Action Provisions | |
| (In thousands) | | Amount | | | Ratio | | | Amount | | | Ratio | | | Amount | | | Ratio | |
| As of December 31, 2008 (Company): | | | | | | | | | | | | | | | | | | |
| Total Capital (to Risk Weighted Assets) | | $ | 89,769 | | | | 13.23 | % | | $ | 54,293 | | | | 8.00 | % | | | N/A | | | | N/A | |
| Tier 1 Capital (to Risk Weighted Assets) | | | 81,225 | | | | 11.97 | % | | | 27,146 | | | | 4.00 | % | | | N/A | | | | N/A | |
| Tier 1 Capital ( to Average Assets) | | | 81,225 | | | | 10.58 | % | | | 23,022 | | | | 3.00 | % | | | N/A | | | | N/A | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| As of December 31, 2008 (Bank): | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Capital (to Risk Weighted Assets) | | $ | 86,161 | | | | 12.61 | % | | $ | 54,680 | | | | 8.00 | % | | $ | 68,351 | | | | 10.00 | % |
| Tier 1 Capital (to Risk Weighted Assets) | | | 78,234 | | | | 11.45 | % | | | 27,340 | | | | 4.00 | % | | | 41,010 | | | | 6.00 | % |
| Tier 1 Capital ( to Average Assets) | | | 78,234 | | | | 10.44 | % | | | 22,479 | | | | 3.00 | % | | | 37,466 | | | | 5.00 | % |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| As of December 31, 2007 - (Company): | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Capital (to Risk Weighted Assets) | | $ | 89,136 | | | | 12.18 | % | | $ | 58,531 | | | | 8.00 | % | | | N/A | | | | N/A | |
| Tier 1 Capital (to Risk Weighted Assets) | | | 79,986 | | | | 10.93 | % | | | 29,265 | | | | 4.00 | % | | | N/A | | | | N/A | |
| Tier 1 Capital ( to Average Assets) | | | 79,986 | | | | 10.30 | % | | | 23,299 | | | | 3.00 | % | | | N/A | | | | N/A | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| As of December 31, 2007 – (Bank): | | | | | | | | | | | | | | | | | | | | | | | | |
| Total Capital (to Risk Weighted Assets) | | $ | 86,294 | | | | 11.79 | % | | $ | 58,531 | | | | 8.00 | % | | $ | 73,164 | | | | 10.00 | % |
| Tier 1 Capital (to Risk Weighted Assets) | | | 77,144 | | | | 10.54 | % | | | 29,265 | | | | 4.00 | % | | | 43,898 | | | | 6.00 | % |
| Tier 1 Capital ( to Average Assets) | | | 77,144 | | | | 9.93 | % | | | 23,299 | | | | 3.00 | % | | | 38,832 | | | | 5.00 | % |
The Board of Governors has also adopted a statement of policy, supplementing its leverage capital ratio requirements, which provides definitions of qualifying total capital (consisting of Tier 1 capital and supplementary capital, including the allowance for loan losses up to a maximum of 1.25% of risk-weighted assets) and sets forth minimum risk-based capital ratios of capital to risk-weighted assets. Insured institutions are required to maintain a ratio of qualifying total capital to risk weighted assets of 8%, at least one-half of which must be in the form of Tier 1 capital. Management believes, as of December 31, 2008, that the Company and the Bank meet all capital adequacy requirements to which they are subject.
As of December 31, 2008 and 2007, the most recent notifications from the Bank’s regulators 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 capital and Tier 1 capital (as defined) to risk-based assets (as defined), and a minimum leverage ratio of Tier 1 capital to average assets (as defined) as set forth in the proceeding discussion. There are no conditions or events since the notification that management believes have changed the institution’s category.
Under regulatory guidelines, the $15 million in Trust Preferred Securities issued by USB Capital Trust II in July of 2008 qualifies as Tier 1 capital up to 25% of Tier 1 capital. Any additional portion of Trust Preferred Securities qualifies as Tier 2 capital.
Dividends - Dividends paid to shareholders are paid by the bank holding company, subject to restrictions set forth in the California General Corporation Law. The primary source of funds with which dividends will be paid to shareholders will come from cash dividends received by the Company from the Bank. Year-to-date as of December 31, 2008, the Company received $4.3 million in cash dividends from the Bank, from which the Company has declared $3.3 million in cash dividends to shareholders.
Under California state banking law, the Bank may not pay cash dividends in an amount which exceeds the lesser of the retained earnings of the Bank or the Bank’s net income for the last three fiscal years (less the amount of distributions to shareholders during that period of time). If the above test is not met, cash dividends may only be paid with the prior approval of the California State Department of Financial Institutions, in an amount not exceeding the greater of: (i) the Bank’s retained earnings; (ii) its net income for the last fiscal year; or (iii) its net income for the current fiscal year. During 2008, the Bank paid dividends of $4.3 million to the Company. Because the distributions made by the Bank to the Holding Company over the past three fiscal years equal the amount of the Bank’s net income for the last three years, at December 31, 2008, the Bank may not pay additional cash dividends without the prior approval of the California State Department of Financial Institutions.
Cash Restrictions - The Bank is required to maintain average reserve balances with the Federal Reserve Bank. During 2005, the Company implemented a deposit reclassification program, which allows the Company to reclassify a portion of transaction accounts to non-transaction accounts for reserve purposes. The deposit reclassification program was provided by a third-party vendor, and has been approved by the Federal Reserve Bank. At both December 31, 2008 and 2007, the Bank’s qualifying balance with the Federal Reserve Bank was $25,000 consisting of vault cash and balances.
| 17. | Supplemental Cash Flow Disclosures |
| | | Years Ended December 31, | |
| (In thousands) | | 2008 | | | 2007 | | | 2006 | |
| Cash paid during the period for: | | | | | | | | | |
| Interest | | $ | 16,193 | | | $ | 21,147 | | | $ | 13,574 | |
| Income Taxes | | | 2,219 | | | | 6,411 | | | | 8,287 | |
| Noncash investing activities: | | | | | | | | | | | | |
| Loans transferred to foreclosed property | | | 28,543 | | | | 7,837 | | | | 0 | |
| Dividends declared not paid | | | 5 | | | | 1,483 | | | | 1,413 | |
| Supplemental disclosures related to acquisitions: | | | | | | | | | | | | |
| Deposits | | | — | | | | 69,600 | | | | — | |
| Other liabilities | | | — | | | | 286 | | | | — | |
| Securities available for sale | | | — | | | | (7,414 | ) | | | — | |
| Loans, net of allowance for loan loss | | | — | | | | (62,426 | ) | | | — | |
| Premises and equipment | | | — | | | | (728 | ) | | | — | |
| Intangibles | | | — | | | | (11,085 | ) | | | — | |
| Accrued interest and other assets | | | — | | | | (3,396 | ) | | | — | |
| Stock issued | | | — | | | | 21,536 | | | | — | |
| Net cash and equivalents acquired | | | — | | | | 6,373 | | | | — | |
On December 16, 2008, the Company’s Board of Directors declared a one-percent (1%) stock dividend on the Company’s outstanding common stock. Based upon the number of outstanding common shares on the record date of January 1, 2009, an additional 118,449 shares were issued to shareholders on January 21, 2009. Because the stock dividend was considered a “small stock dividend”, approximately $1.4 million was transferred from retained earnings to common stock based upon the $12.00 closing price of the Company’s common stock on the declaration date of December 16, 2008. Fractional shares were paid in cash, with a cash-in-lieu of payment of approximately $5,000.
On September 23, 2008, the Company’s Board of Directors declared a one-percent (1%) stock dividend on the Company’s outstanding common stock. Based upon the number of outstanding common shares on the record date of October 10, 2008, an additional 117,732 shares were issued to shareholders on October 22, 2008. Because the stock dividend was considered a “small stock dividend”, approximately $1.8 million was transferred from retained earnings to common stock based upon the $15.65 closing price of the Company’s common stock on the declaration date of September 23, 2008. Fractional shares were paid in cash, with a cash-in-lieu of payment of approximately $4,000.
Other than for earnings-per-share calculations, shares issued for the two stock dividends have been treated prospectively from December 31, 2008 for financial reporting purposes. For purposes of earnings per share calculations, the Company’s weighted average shares outstanding and potentially dilutive shares used in the computation of earnings per share have been restated after giving retroactive effect to the 1% stock dividends to shareholders for all periods presented.
The following table provides a reconciliation of the numerator and the denominator of the basic EPS computation with the numerator and the denominator of the diluted EPS computation. (Weighted average shares have been adjusted to give retroactive recognition for 2-for-1 stock split during May 2006 and 1% stock dividend for each of the quarters ended September 30, 2008 and December 31, 2008):
| | | Years Ended December 31, | |
| (In thousands, except earnings per share data) | | 2008 | | | 2007 | | | 2006 | |
| | | | | | | | | | |
| Net income available to common shareholders | | $ | 4,070 | | | $ | 11,257 | | | $ | 13,360 | |
| Weighted average shares outstanding | | | 12,049 | | | | 12,165 | | | | 11,572 | |
| Add: dilutive effect of stock options | | | 3 | | | | 36 | | | | 121 | |
| Weighted average shares outstanding adjusted for potential dilution | | | 12,052 | | | | 12,201 | | | | 11,693 | |
| Basic earnings per share | | $ | 0.34 | | | $ | 0.93 | | | $ | 1.15 | |
| Diluted earnings per share | | $ | 0.34 | | | $ | 0.92 | | | $ | 1.14 | |
| Anti-dilutive shares excluded from earnings per share calculation | | | 109 | | | | 58 | | | | 34 | |
| 20. | Other Comprehensive Income |
The following table provides a reconciliation of the amounts included in comprehensive income:
| | | Years Ended December 31 | |
| (In thousands) | | 2008 | | | 2007 | | | 2006 | |
| Unrealized (loss) gain on available-for-sale securities: | | | | | | | | | |
| Unrealized (loss) gain on sale securities – net of income tax (benefit) of ($1,900), $605, and $253 | | | (2,850 | ) | | $ | 909 | | | $ | 379 | |
| Less: Reclassification adjustment for loss (gain) on sale of available-for-sale securities included in net income -net of income tax (benefit) of $10, $0, and $11 | | | (15 | ) | | | 0 | | | | (16 | ) |
| | | | | | | | | | | | | |
| Net unrealized (loss) gain on available-for-sale securities - net income tax (benefit) of ($1,910), $605, and $242 | | $ | (2,865 | ) | | $ | 909 | | | $ | 363 | |
| | | | | | | | | | | | | |
| Unrealized loss on interest rate swaps: | | | | | | | | | | | | |
| Unrealized losses arising during period – net of income tax benefit of $1, $110, and $150 | | $ | (3 | ) | | $ | (165 | ) | | $ | (225 | ) |
| Less: reclassification adjustments to interest income | | | 5 | | | | 310 | | | | 493 | |
| | | | | | | | | | | | | |
| Net change in unrealized loss on interest rate swaps - net of income tax $1, $97, and $140 | | $ | 2 | | | $ | 145 | | | $ | 268 | |
| | | | | | | | | | | | | |
Previously unrecognized past service costs of employee benefit plans - net tax of $62 and $55 | | $ | 93 | | | $ | 85 | | | | — | |
| Total other comprehensive income (loss) | | $ | (2,770 | ) | | $ | 1,137 | | | $ | 631 | |
| 21. | Derivative Financial Instruments and Hedging Activities |
As part of its overall risk management, the Company pursues various asset and liability management strategies, which may include obtaining derivative financial instruments to mitigate the impact of interest fluctuations on the Company’s net interest margin. During the second quarter of 2003, the Company entered into an interest rate swap agreement with the purpose of minimizing interest rate fluctuations on its interest rate margin and equity.
Under the interest rate swap agreement, the Company received a fixed rate and pays a variable rate based on the Prime Rate (“Prime”). The swap qualified as a cash flow hedge under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”, as amended, and was designated as a hedge of the variability of cash flows the Company receives from certain variable-rate loans indexed to Prime. In accordance with SFAS No. 133, the swap agreement was measured at fair value and reported as an asset or liability on the consolidated balance sheet. The portion of the change in the fair value of the swap that was deemed effective in hedging the cash flows of the designated assets was recorded in accumulated other comprehensive income and reclassified into interest income when such cash flows occurred in the future. Any ineffectiveness resulting from the hedge was recorded as a gain or loss in the consolidated statement of income as part of noninterest income.
The amortizing hedge matured in September 2008. During the year ended December 31, 2008, $5,000 was reclassified from other accumulated comprehensive income into expense, and is reflected as a reduction in interest income. The Company recorded pretax hedge gains related to swap ineffectiveness of approximately $9,100 during the year ended December 31, 2008. Amounts recognized as hedge ineffectiveness gains or losses are reflected in noninterest income.
At December 31, 2007, the amortizing hedge had a remaining notional value of $1.8 million and a duration of approximately three months. As of December 31, 2007, the net loss amounts in accumulated other comprehensive income associated with these cash flows totaled $2,000. During the year ended December 31, 2007, $310,000 was reclassified from accumulated other comprehensive income as a reduction to interest income. As of December 31, 2007, the amounts in accumulated OCI associated with these cash flows that were expected to be reclassified into interest income during the remainder of the hedge instrument in 2008 totaled $9,000.
At December 31, 2008 and 2007, the information pertaining to the outstanding interest rate swap is as follows:
| | | December 31, | | | December 31, | |
| (000’s in millions) | | 2008 | | | 2007 | |
| Notional amount | | | — | | | $ | 1,753 | |
| Weighted average pay rate | | | — | | | | 8.05 | % |
| Weighted average receive rate | | | — | | | | 4.88 | % |
| Weighted average maturity in years | | | — | | | | 0.3 | |
| Unrealized loss relating to interest rate swaps | | | — | | | $ | 12 | |
The Company performed a quarterly analysis of the effectiveness of the interest rate swap agreement at December 31, 2007 and for each of the quarters ended March 31, 2008 and June 30, 2008. As a result of a correlation analysis, the Company determined that the swap remained highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge and, therefore, continued to qualify for hedge accounting under the guidelines of SFAS No. 133. However, during the second quarter of 2006, the Company determined that the underlying loans being hedged were paying off faster than the notional value of the hedge instrument was amortizing. This difference between the notional value of the hedge and the underlying hedged assets is considered an “overhedge” pursuant to SFAS No. 133 guidelines and may constitute ineffectiveness if the difference is other than temporary. The Company determined during 2006 that the difference was other than temporary and, as a result, reclassified a net total of $75,000 of the pretax hedge loss reported in other comprehensive income into earnings during 2006. As of December 31, 2007, the notional value of the hedge was still in excess of the value of the underlying loans being hedged by approximately $1.3 million, but had improved from the $3.3 million difference existing at December 31, 2006. As a result, the Company recorded a pretax hedge gain related to swap ineffectiveness of approximately $66,000 during the December 31, 2007. With the interest rate swap maturing on September 30, 2009, the Company recognized the remaining hedge ineffectiveness gains of $9,000 during the nine months ended September 30, 2008. Amounts recognized as hedge ineffectiveness gains or losses are reflected in noninterest income.
| 22. | Investment in Bank Stock |
During December 2007, the Company purchased 33,854 common shares of Northern California Bancorp, Inc. (NRLB) in a privately negotiated transaction for a price of $11.50 per share or approximately $389,000. This purchase equals approximately 1.9% of NRLB’s outstanding stock and will be treated as a marketable equity investment by the Company with changes in fair value recorded in earnings. NRLB is the holding company of Monterey County Bank. At December 31, 2007, the Company recorded a loss in its equity investment in NRLB of $17,000 based on a quoted market price of $11.00 per share at that date. The Company may purchase additional common shares of NRLB as shares become available.
During the first quarter of 2008, the Company more thoroughly reviewed its equity position in NRLB stock and determined that the stock should more properly be accounted for as available-for-sale-securities (“AFS”) under the guidelines of SFAS No. 115. Management’s decision was based upon the fact that these were clearly not trading securities. For this reason, the Company reclassified the NRLB stock holdings as available-for-sale securities effective January 1, 2008.
During the first quarter of 2008, the Company purchased an additional 6,517 shares at average price of $11.00 per share bringing the total shares owned to 40,371 at a total carrying value of $444,000. No further purchases we made during the remainder of 2008.
As with other debt and equity securities, the investment in NRLB stock is reviewed for other-than-temporary impairment under the guidelines of SFAS No. 115-1. Although the Company has recorded an unrealized AFS loss of $323,000 ($194,000 net of tax) through other comprehensive income at December 31, 2008 pursuant to SFAS No. 115, management has determined that the equity investment is not other-than-temporarily impaired at December 31, 2008. The AFS valuation was based upon a market price of $3.00 per share for NRLB’s stock at December 31, 2008. The Company believes this price is reflective of general market and economic conditions which have severely impacted financial stocks. The Company will continue to review its investment in NRLB stock on an ongoing basis as the economy recovers to determine whether the investment in NRLB stock is other-than-temporarily impaired.
On March 28, 2006, the Company’s Board of Directors approved a 2-for-1 stock split of the Company’s no par common stock effected in the form of a 100% stock dividend. The stock dividend was payable May 1, 2006 to shareholders of record as of April 7, 2006. Effective May 1, 2006, each shareholder received one additional share for each common share held as of the record date. All periods presented in the financial statements have been restated to reflect the effect of the 2-for-1 stock split.
| 24. | Common Stock Repurchase Plan |
During August 2001, the Company’s Board of Directors approved a plan to repurchase, as conditions warrant, up to 280,000 shares (effectively 580,000 shares adjusted for 2-for-1 stock split in May 2006) of the Company’s common stock on the open market or in privately negotiated transactions. The duration of the program is open-ended and the timing of the purchases will depend on market conditions.
On February 25, 2004, the Company announced another stock repurchase plan under which the Board of Directors approved a plan to repurchase, as conditions warrant, up to 276,500 shares (effectively 553,000 shares adjusted for 2-for-1 stock split in May 2006) of the Company's common stock on the open market or in privately negotiated transactions. As with the first plan, the duration of the new program is open-ended and the timing of purchases will depend on market conditions. Concurrent with the approval of the new repurchase plan, the Board terminated the 2001 repurchase plan. During the year ended December 31, 2005, 13,081 shares (26,162 shares effected for 2006 2-for-1 stock split) were repurchased at a total cost of $377,000 and an average price per share of $28.92 ($14.46 effected for 2006 2-for-1 stock split). During the year ended December 31, 2006, 108,005 shares were repurchased at a total cost of $2.4 million and an average price per share of $22.55.
On May 16, 2007, the Company announced a third stock repurchase plan to repurchase, as conditions warrant, up to 610,000 shares of the Company's common stock on the open market or in privately negotiated transactions. The repurchase plan represents approximately 5.00% of the Company's currently outstanding common stock. The duration of the program is open-ended and the timing of purchases will depend on market conditions. Concurrent with the approval of the new repurchase plan, the Company canceled the remaining 75,733 shares available under the 2004 repurchase plan.
During the year ended December 31, 2007, 512,332 shares were repurchased at a total cost of $10.1 million and an average per share price of $19.71. Of the shares repurchased during 2007, 166,660 shares were repurchased under the 2004 plan at an average cost of $20.46 per shares, and 345,672 shares were repurchased under the 2007 plan at an average cost of $19.35 per shares.
During the year ended December 31, 2008, 89,001 shares were repurchased at a total cost of $1.2 million and an average per share price of $13.70.
On February 16, 2007, the Company acquired 100 percent of the outstanding common shares of Legacy Bank, N.A., located in Campbell, California. At merger, Legacy Bank’s one branch was merged with and into United Security Bank, a wholly owned subsidiary of the Company. The purchase of Legacy Bank provided the Company with an opportunity to expand its market area into Santa Clara County and to serve a loyal and growing small business niche and individual client base build by Legacy.
The aggregate purchase price for Legacy was $21.7 million, which included $177,000 in direct acquisition costs related to the merger. At the date of merger, Legacy Bank had 1,674,373 shares of common stock outstanding. Based upon an exchange rate of approximately .58 shares of the Company’s stock for each share of Legacy stock, Legacy shareholders received 976,411 shares of the Company’s common stock, amounting to consideration of approximately $12.86 per Legacy common share.
Legacy’s results of the operations have been included in the Company’s results beginning February 17, 2007.
During the second quarter of 2007, the Company re-evaluated the preliminary estimate of the core deposit intangible related to savings accounts acquired from Legacy and determined that the initial run-off of those deposits was faster than originally anticipated. As a result, the Company reduced the core deposits intangible by approximately $215,000 from the amount reported at March 31, 2007. Correspondingly, resultant goodwill was increased by that same $215,000. During the fourth quarter of 2007 recorded the final purchase accounting adjustments which reflected Legacy’s final book-to-tax deferred tax amounts, and other deferred tax adjustments related to purchase accounting guidelines under SFAS No. 141. The result of adjustments made during the fourth quarter of 2007 was to increase the recorded NOL benefit by $22,000, record deferred tax liabilities of $727,000, and to increase goodwill by $705,000.
The following summarizes the purchase and the resultant allocation to fair-market-value adjustments and goodwill:
| Purchase Price: | | | |
| Total value of the Company's common stock exchanged | | $ | 21,536 | |
| Direct acquisition costs | | | 177 | |
| Total purchase price | | | 21,713 | |
| Allocation of Purchase Price: | | | | |
| Legacy's shareholder equity | | | 8,588 | |
| Estimated adjustments to reflect assets acquired and liabilities assumed at fair value: | |
| | |
| Investments | | | 23 | |
| Loans | | | (118 | ) |
| Deferred taxes | | | 1,430 | |
| Core Deposit Intangible | | | 3,000 | |
| Estimated fair value of net assets acquired | | | 12,923 | |
| Goodwill resulting from acquisition | | $ | 8,790 | |
The following condensed balance sheet summarizes the amount assigned for each major asset and liability category of Legacy at the merger date:
| Assets: | | | |
| Cash | | $ | 3,173 | |
| Federal Funds Purchased | | | 3,200 | |
| Securities available for sale | | | 7,414 | |
| Loans, net of allowance for loan losses | | | 62,426 | |
| Premises and equipment | | | 729 | |
| Deferred taxes | | | 1,430 | |
| Core deposit intangibles | | | 3,000 | |
| Goodwill | | | 8,790 | |
| Accrued interest and other assets | | | 1,437 | |
| Total Assets | | $ | 91,599 | |
| Liabilities: | | | | |
| Deposits: | | | | |
| Non-interest bearing | | $ | 17,262 | |
| Interest-bearing | | | 52,338 | |
| Total deposits | | $ | 69,600 | |
| Accrued interest payable and other liabilities | | | 286 | |
| Total liabilities | | $ | 69,886 | |
| Net assets assigned to purchase | | $ | 21,713 | |
The merger transaction was accounted for using the purchase accounting method, and resulted in the purchase price being allocated to the assets acquired and liabilities assumed from Legacy Bank based on the fair value of those assets and liabilities. The allocations of purchase price based upon the fair value of assets acquired and liabilities assumed were finalized during the fourth quarter of 2007. Management believes the Company will be able to fully utilize the net operating loss carry-forward (NOL) obtained in the Legacy merger. The Company has utilized a fair value approach for Legacy’s loan portfolio which includes certain market rate assumptions on segmented portions of the loan portfolio with similar credit characteristics, and credit risk assumptions specific to the individual loans within that portfolio.
Core deposit intangibles with an original carrying value of $3.0 million are being amortized for financial statement purposes over an estimated life of approximately 7 years using a method that approximates the interest method. Core deposit intangibles are reviewed for impairment on an annual basis. During the first quarter of 2008, the Company performed an impairment analysis of the core deposit intangibles associated with the Legacy Bank purchase. At that time it was determined that the core deposits were declining faster than originally anticipated. As a result, the Company recognized an impairment loss of $624,000 for the quarter ended March 31, 2008 (see Note 26 below).
Goodwill totaling $8.8 million is not being amortized for book purposes under current accounting guidelines. Because the merger was a tax-deferred stock-for-stock purchase, goodwill is not deductible for tax purposes. Goodwill will be reviewed for impairment on an annual basis. The Company has determined that there is no goodwill impairment as of December 31, 2008.
| 26. | Impairment Loss – Core Deposit Intangible |
The Company conducts periodic impairment analysis on its intangible assets and goodwill. Impairment analysis is performed at least annually or more often as conditions require.
During the first quarter of 2008, the Company performed an impairment analysis of the goodwill and core deposit intangible assets associated with the Legacy Bank merger completed during February 2007. The original goodwill and core deposit intangible assets recorded as a result of the Legacy merger totaled $8.8 million and $3.0 million respectively. Goodwill is not amortized. The core deposit intangible asset is being amortized over an estimated life of approximately seven years.
During the impairment analysis performed as of March 31, 2008, it was determined that the original deposits purchased from Legacy Bank during February 2007 had declined faster than originally anticipated when the core deposit intangible was calculated at the time of the merger. As a result of increased deposit runoff, particularly in interest-bearing and noninterest-bearing checking accounts, the estimated value of the Legacy core deposit intangible was determined to be $1.6 million at March 31, 2008 rather than the pre-adjustment carrying value of $2.3 million. As a result of the impairment analysis, the Company recorded a pre-tax impairment loss of $624,000 ($364,000 net of tax) reflected as a component of noninterest expense for the quarter ended March 31, and the year ended December 31, 2008. Pursuant to the impairment analysis conducted as of March 31, 2008, the Company determined that there was no impairment to the goodwill related to the Legacy merger. During the quarter ended December 31, 2008, the Company reviewed the Legacy core deposit intangible and goodwill, and determined that there was no additional impairment.
During the year ended December 31, 2008, the Company recorded $523,000 of amortization expense related to the Legacy core deposit intangible asset bringing the net carrying value to $1.3 million at December 31, 2008.
| 27. | Parent Company Only Financial Statements |
The following are the condensed financial statements of United Security Bancshares and should be read in conjunction with the consolidated financial statements:
United Security Bancshares – (parent only)
Balance Sheets - December 31, 2008 and 2007
| (In thousands) | | 2008 | | | 2007 | |
| Assets | | | | | | |
| Cash and equivalents | | $ | 357 | | | $ | 2,546 | |
| Investment in bank subsidiary | | | 91,814 | | | | 94,589 | |
| Investment in nonbank entity | | | 99 | | | | 122 | |
| Investment in bank stock | | | 121 | | | | 372 | |
| Other assets | | | 476 | | | | 470 | |
| Total assets | | $ | 92,867 | | | $ | 98,099 | |
| | | | | | | | | |
| Liabilities & Shareholders' Equity | | | | | | | | |
| Liabilities: | | | | | | | | |
| Junior subordinated debt securities (at fair value) 12/31/07) | | $ | 11,926 | | | $ | 13,341 | |
| Accrued interest payable | | | 0 | | | | 0 | |
| Deferred taxes | | | 1,436 | | | | 998 | |
| Other liabilities | | | (105 | ) | | | 1,329 | |
| Total liabilities | | | 13,257 | | | | 15,668 | |
| | | | | | | | | |
| Shareholders' Equity: | | | | | | | | |
| Common stock, no par value 20,000,000 shares authorized, 12,010,372 and 11,855,192 issued and outstanding, in 2008 and 2007 | | | 34,811 | | | | 32,587 | |
| Retained earnings | | | 47,722 | | | | 49,997 | |
| Accumulated other comprehensive loss | | | (2,923 | ) | | | (153 | ) |
| Total shareholders' equity | | | 79,610 | | | | 82,431 | |
| Total liabilities and shareholders' equity | | $ | 92,867 | | | $ | 98,099 | |
United Security Bancshares – (parent only)
Income Statements
| | | Years Ended December 31, | |
| (In thousands) | | 2008 | | | 2007 | | | 2006 | |
| Income | | | | | | | | | |
| Dividends from subsidiaries | | $ | 4,250 | | | $ | 17,600 | | | $ | 7,300 | |
| Gain on fair value option of financial assets | | | 1,363 | | | | 2,504 | | | | 0 | |
| Other income | | | 10 | | | | 0 | | | | 0 | |
| Total income | | | 5,623 | | | | 20,104 | | | | 7,300 | |
| Expense | | | | | | | | | | | | |
| Interest expense | | | 734 | | | | 1,234 | | | | 1,355 | |
| Other expense | | | 401 | | | | 469 | | | | 378 | |
| Total expense | | | 1,135 | | | | 1,703 | | | | 1,733 | |
| Income before taxes and equity in undistributed income of subsidiary | | | 4,488 | | | | 18,401 | | | | 5,567 | |
| Income tax expense (benefit) | | | 108 | | | | 337 | | | | (729 | ) |
| (Deficit) equity in undistributed income of subsidiary | | | (310 | ) | | | (6,807 | ) | | | 7,064 | |
| Net Income | | $ | 4,070 | | | $ | 11,257 | | | $ | 13,360 | |
United Security Bancshares – (parent only)
Statement of Cash Flows
| | | Years Ended December 31, | |
| (In thousands) | | 2008 | | | 2007 | | | 2006 | |
| Cash Flows From Operating Activities | | | | | | | | | |
| Net income | | $ | 4,070 | | | $ | 11,257 | | | $ | 13,360 | |
| Adjustments to reconcile net earnings to cash provided by operating activities: | | | | | | | | | | | | |
| Deficit (equity) in undistributed income of subsidiary | | | 310 | | | | 6,807 | | | | (7,064 | ) |
| Deferred taxes | | | 567 | | | | 998 | | | | 0 | |
| Write-down of other investments | | | 23 | | | | 17 | | | | 0 | |
| Gain on fair value option of financial liability | | | (1,363 | ) | | | (2,504 | ) | | | 0 | |
| Amortization of issuance costs | | | 0 | | | | 0 | | | | 17 | |
| Net change in other liabilities | | | (15 | ) | | | 381 | | | | 297 | |
| Net cash provided by operating activities | | | 3,592 | | | | 16,956 | | | | 6,610 | |
| | | | | | | | | | | | | |
| Cash Flows From Investing Activities | | | | | | | | | | | | |
| Investment in bank stock | | | (72 | ) | | | (389 | ) | | | 0 | |
| Proceeds from sale of investment in title company | | | 0 | | | | 0 | | | | 149 | |
| Net cash (used in) provided by investing activities | | | (72 | ) | | | (389 | ) | | | 149 | |
| | | | | | | | | | | | | |
| Cash Flows From Financing Activities | | | | | | | | | | | | |
| Proceeds from stock options exercised | | | 70 | | | | 510 | | | | 335 | |
| Net proceeds from issuance of junior subordinated debt | | | 0 | | | | (923 | ) | | | 0 | |
| Repurchase and retirement of common stock | | | (1,220 | ) | | | (10,095 | ) | | | (2,436 | ) |
| Payment of dividends on common stock | | | (4,559 | ) | | | (5,930 | ) | | | (4,881 | ) |
| Net cash used in financing activities | | | (5,709 | ) | | | (16,438 | ) | | | (6,982 | ) |
| | | | | | | | | | | | | |
| Net (decrease) increase in cash and cash equivalents | | | (2,189 | ) | | | 129 | | | | (223 | ) |
| Cash and cash equivalents at beginning of year | | | 2,546 | | | | 2,417 | | | | 2,640 | |
| Cash and cash equivalents at end of year | | $ | 357 | | | $ | 2,546 | | | $ | 2,417 | |
| | | | | | | | | | | | | |
| Supplemental cash flow disclosures | | | | | | | | | | | | |
| Noncash financing activities: | | | | | | | | | | | | |
| Dividends declared not paid | | $ | 5 | | | $ | 1,483 | | | $ | 1,413 | |
| 28. | Quarterly Financial Data (unaudited) |
Selected quarterly financial data for the years ended December 31, 2008 and 2007 are presented below:
| | | 2008 | | | 2007 | |
| (In thousands except per share data) | | 4th | | | 3rd | | | 2nd | | | 1st | | | 4th | | | 3rd | | | 2nd | | | 1st | |
| Interest income | | $ | 10,036 | | | $ | 10,936 | | | $ | 11,431 | | | $ | 12,744 | | | $ | 14,245 | | | $ | 14,713 | | | $ | 13,962 | | | $ | 14,236 | |
| Interest expense | | | 2,967 | | | | 3,509 | | | | 3,702 | | | | 4,759 | | | | 5,450 | | | | 5,494 | | | | 5,126 | | | | 4,503 | |
| Net interest income | | | 7,069 | | | | 7,427 | | | | 7,729 | | | | 7,985 | | | | 8,795 | | | | 9,219 | | | | 8,836 | | | | 9,733 | |
| Provision for credit losses | | | 2,383 | | | | 6,402 | | | | 548 | | | | 265 | | | | 3,337 | | | | 1,950 | | | | 208 | | | | 202 | |
| Gain (loss) on sale of securities | | | 0 | | | | 0 | | | | 0 | | | | 24 | | | | 0 | | | | 0 | | | | 0 | | | | 0 | |
| Other noninterest income | | | 2,698 | | | | 1,591 | | | | 1,721 | | | | 2,309 | | | | 2,110 | | | | 4,019 | | | | 1,954 | | | | 1,581 | |
| Noninterest expense | | | 6,254 | | | | 5,265 | | | | 5,644 | | | | 6,116 | | | | 6,723 | | | | 5,292 | | | | 5,517 | | | | 5,200 | |
| Income before income tax expense | | | 1,130 | | | | (2,649 | ) | | | 3,258 | | | | 3,937 | | | | 845 | | | | 5,996 | | | | 5,065 | | | | 5,912 | |
| Income tax expense | | | 289 | | | | (1,308 | ) | | | 1,188 | | | | 1,437 | | | | 156 | | | | 2,339 | | | | 1,757 | | | | 2,309 | |
| Net income | | $ | 841 | | | $ | (1,341 | ) | | $ | 2,070 | | | $ | 2,500 | | | $ | 689 | | | $ | 3,657 | | | $ | 3,308 | | | $ | 3,603 | |
| Net income per share: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Basic | | $ | 0.07 | | | $ | (0.11 | ) | | $ | 0.17 | | | $ | 0.21 | | | $ | 0.06 | | | $ | 0.31 | | | $ | 0.27 | | | $ | 0.30 | |
| Diluted | | $ | 0.07 | | | $ | (0.11 | ) | | $ | 0.17 | | | $ | 0.21 | | | $ | 0.06 | | | $ | 0.31 | | | $ | 0.27 | | | $ | 0.30 | |
| Dividends declared per share | | | — | | | | — | | | $ | 0.13 | | | $ | 0.13 | | | $ | 0.125 | | | $ | 0.125 | | | $ | 0.125 | | | $ | 0.125 | |
| Average shares outstanding | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| For net income per share: | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Basic | | | 12,024 | | | | 12,035 | | | | 12,056 | | | | 12,084 | | | | 11,887 | | | | 11,925 | | | | 12,078 | | | | 11,947 | |
| Diluted | | | 12,024 | | | | 12,041 | | | | 12,059 | | | | 12,094 | | | | 11,900 | | | | 11,946 | | | | 12,135 | | | | 12,006 | |
Item 9 - Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures:
a) As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures, as defined in the Securities and Exchange Act Rule 13(a)-15(e). Based upon that evaluation, the CEO and CFO concluded that, as of the end of the period covered in this report, the Company’s disclosure controls and procedures were effective to ensure that information required to be disclosed by the Company in reports that it files under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms, and that material information relating to our consolidated operations is made known to the Company’s management, including the CEO and CFO, particularly during the period when the Company’s periodic reports are being prepared.
(b) Changes in Internal Controls over Financial Reporting:
At September 30, 2008, the Company determined that its disclosure controls and procedures were not effective as the result of an identified material weakness related to the allowance for loan and lease losses and the completeness and accuracy of the provision for loan and lease losses. Specifically the Company did not:
| | · | Maintain sufficient policies and procedures to ensure that line personnel perform an analysis adequate to risk classify the current loan portfolio. |
| | · | Effectively have an adequate number of qualified and trained personnel in our credit administration to sufficiently identify problem loans timely. |
| | · | Maintain policies and procedures to ensure that SFAS 114 Accounting by Creditors for Impairment of a Loan documentation is prepared timely, accurately and subject to supervisory review. |
During the fourth quarter of 2008, the Company undertook steps to remediate the material weakness identified at September 31, 2008. Given the significant increase in problem loan levels experienced during 2008, Management’s objective was to improve staffing levels involved in the review process of the allowance for loan and lease losses, to ensure more timely and accurate identification and classification of problem and impaired loans, and to make sure that loss recognition, if required, was properly recorded on a timely basis.
Specific remediation steps taken during the fourth quarter of 2008 included:
| | · | A thorough review of the Company’s policies and procedures related to risk classifications of problem loans, SFAS 114, and the periodic review process to determine the adequacy of the allowance for loan and lease losses. |
| | · | Formation of a committee comprised of members of the Company’s management and loan administration for the purpose of meeting on an ongoing basis to identify, classify, and properly provide an adequate level of allowance for loan and lease losses for the loan portfolio. |
| | · | More in-depth review and verification of the allowance for loan and lease losses by the Accounting and Credit Administration departments to ensure its completeness and accuracy. |
As of December 31, 2008, the Company concluded that the material weakness discussed above had been successfully remediated and that disclosure controls and procedures related to the allowance for loan and lease losses and the completeness and accuracy of the provision for loan lease losses were effective as of December 31, 2008.
Other than the material weakness discussed above, there were no additional changes in the Company’s internal control over financial reporting that occurred during the fourth quarter of 2008 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
Management Report on Internal Control over Financial Reporting:
MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING
Management of United Security Bancshares and Subsidiaries (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting, and for performing an assessment of the effectiveness of internal control over financial reporting as of December 31, 2008. The Company’s internal control over financial reporting is a process designed under the supervision of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States.
The Company’s system of internal control over financial reporting includes policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect transactions and dispositions of assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Management recognizes that there are inherent limitations in the effectiveness of any system of internal control, and accordingly, even effective internal control can provide only reasonable assurance with respect to financial statement preparation and fair presentation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.
Under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company performed an assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2008 based upon criteria in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, Management determined that the Company’s internal control over financial reporting was effective as of December 31, 2008.
The Company’s independent registered public accounting firm, Moss Adams LLP, who audits the Company’s consolidated financial statements, have issued an attestation report on the effectiveness of the Company’s internal control over financial reporting. This report is included in Item 8, “financial statements and supplementary data” to the Form 10-K.
Item 9B. Other Information
None
PART III
Item 10 – Directors, Executive Officers, and Corporate Governance
Pursuant to Instruction G, the information required by this item is hereby incorporated herein by reference from the captions entitled "Election of Directors and Executive Officers" and “Corporate Governance Principles and Board Matters” set forth in the Company's definitive Proxy Statement for its 2009 Annual Meeting of Shareholders ("Proxy Statement").
Item 11 - Executive Compensation
Pursuant to Instruction G, the information required by this item is hereby incorporated herein by reference from the captions entitled "Executive Compensation" and “Director Compensation” set forth in the Company's definitive Proxy Statement for its 2009 Annual Meeting of Shareholders ("Proxy Statement").
Item 12 - Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Pursuant to Instruction G, the information required by this item is hereby incorporated herein by reference from the caption entitled "Shareholdings of Certain Beneficial Owners and Management" set forth in the Company's definitive Proxy Statement for its 2009 Annual Meeting of Shareholders ("Proxy Statement").
Item 13 - Certain Relationships and Related Transactions, and Director Independence
Pursuant to Instruction G, the information required by this item is hereby incorporated herein by reference from the captions entitled "Certain Transactions" and “Corporate Governance Principles” set forth in the Company's definitive Proxy Statement for its 2009 Annual Meeting of Shareholders ("Proxy Statement").
Item 14. Principal Accounting Fees and Services
Pursuant to Instruction G, the information required by this item is hereby incorporated herein by reference from the caption entitled "Independent Accountant Fees and Services" set forth in the Company's definitive Proxy Statement for its 2009 Annual Meeting of Shareholders ("Proxy Statement").
PART IV
Item 15 – Exhibits and Financial Statement Schedules
| (a)(1) | Financial Statements |
The Consolidated Financial Statements and related documents set forth in “Item 8. Financial Statements and Supplementary Data” of this report are filed as part of this report.
| (a)(2) | Financial Statement Schedules |
All financial statement schedules are omitted because they are not applicable or not required or because the information is included in the financial statements or notes thereto or is not material.
| 3.1 | Articles of Incorporation of Registrant (1) |
| 3.2 | Bylaws of Registrant (1) |
| 4.1 | Specimen common stock certificate of United Security Bancshares (1) |
| 10.1 | Amended and Restated Executive Salary Continuation Agreement for Dennis Woods (4) |
| 10.2 | Amended and Restated Employment Agreement for Dennis R. Woods (4) |
| 10.3 | Amended and Restated Executive Salary Continuation Agreement for Kenneth Donahue (4) |
| 10.4 | Amended and Restated Change in Control Agreement for Kenneth Donahue (4) |
| 10.5 | Amended and Restated Executive Salary Continuation Agreement for David Eytcheson (4) |
| 10.6 | Amended and Restated Change in Control Agreement for David Eytcheson (4) |
| 10.7 | Amended and Restated Executive Salary Continuation Agreement for Rhodlee Braa (4) |
| 10.8 | Amended and Restated Change in Control Agreement for Rhodlee Braa (4) |
| 10.9 | Amended and Restated Executive Salary Continuation Agreement for William F. Scarborough (4) |
| 10.10 | Amended and Restated Change in Control Agreement for William F. Scarborough (4) |
| 10.11 | USB 2005 Stock Option Plan. Filed as Exhibit B to the Company's 2005 Schedule 14A Definitive Proxy filed April 18, 2005 and incorporated herein by reference. |
| 10.12 | Stock Option Agreement for William F. Scarborough dated August 1, 2005 (2) |
| 10.13 | Stock Option Agreement for Dennis R. Woods dated February 6, 2006 (3) |
| 11.1 | Computation of earnings per share. |
See Note 19 to Consolidated Financial Statements and related documents set forth in “Item 8. Financial Statements and Supplementary Data” of this report are filed as part of this report.
| 21 | Subsidiaries of the Company |
| 23.1 | Consent of Moss Adams LLP, Independent Registered Public Accounting Firm |
| 31.1 | Certification of the Chief Executive Officer of United Security Bancshares pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 31.2 | Certification of the Chief Financial Officer of United Security Bancshares pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 32.1 | Certification of the Chief Executive Officer of United Security Bancshares pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| 32.2 | Certification of the Chief Financial Officer of United Security Bancshares pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
(1) Previously filed on April 4, 2001 as an exhibit to the Company’s filing on Form S-4 (file number 333-58256).
(2) Previously filed on March 15, 2006 as an exhibit to the Company’s filing on Form 10-K for the year ended December 31, 2006 (file number 000-32987).
(3) Previously filed on November 7, 2006 as an exhibit to the Company’s filing on Form 10-Q/A for the period ended March 31, 2006 (file number 000-32987).
(4) Previously filed on March 17, 2007 as an exhibit to the Company’s filing on Form 10-K for the year ended December 31, 2007 (file number 000-32987).
See Exhibit Index under Item 15(a)(3) above for the list of exhibits required to be filed by Item 601 of regulation S-K with this report.
| (c) | Financial statement schedules filed: |
See Item 15(a)(2) above.
Signatures
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report on Form 10-K for the year ended December 31, 2008 to be signed on its behalf by the undersigned thereunto duly authorized, in Fresno, California, on the 16th day of March, 2009
United Security Bancshares
| March 16, 2009 | /S/ Dennis R. Woods |
| | Dennis R. Woods |
| | President and Chief Executive Officer |
| | |
| March 16, 2009 | /S/ Kenneth L. Donahue |
| | Kenneth L. Donahue |
| | Senior Vice President and |
| | Chief Financial Officer |
| | |
| March 16, 2009 | /S/ Richard B. Shupe |
| | Richard B. Shupe |
| | Vice President and |
| | Controller |
Signatures
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities on the date indicated:
| | Date: | 3/16/2009 | | /s/ Robert G. Bitter | |
| | | | | Director | |
| | | | | | |
| | Date: | 3/16/2009 | | /s/ Stanley J. Cavalla | |
| | | | | Director | |
| | | | | | |
| | Date: | 3/16/2009 | | /s/ Tom Ellithorpe | |
| | | | | Director | |
| | | | | | |
| | Date: | 3/16/2009 | | /s/ R. Todd Henry | |
| | | | | Director | |
| | | | | | |
| | Date: | 3/16/2009 | | /s/ Ronnie D. Miller | |
| | | | | Director | |
| | | | | | |
| | Date: | 3/16/2009 | | /s/ Robert M. Mochizuki | |
| | | | | Director | |
| | | | | | |
| | Date: | 3/16/2009 | | /s/ Walter Reinhard | |
| | | | | Director | |
| | | | | | |
| | Date: | 3/16/2009 | | /s/ John Terzian | |
| | | | | Director | |
| | | | | | |
| | Date: | 3/16/2009 | | /s/ Mike Woolf | |
| | | | | Director | �� |
