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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005
Commission file number: 000-50050
Center Financial Corporation
(Exact name of Registrant as specified in its charter)
California | 52-2380548 | |
(State of Incorporation) | (IRS Employer Identification No) |
3435 Wilshire Boulevard, Suite 700, Los Angeles, California 90010
(Address of principal executive offices)
(213) 251-2222
(Registrant’s telephone number, including area code)
Not Applicable
(Former name, former address and former fiscal year, if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.
¨ Yes x No
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).
x Yes ¨ No
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
As of July 31, 2005, there were 16,384,065 outstanding shares of the issuer’s Common Stock with no par value.
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FORM 10-Q
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ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK | 48 | |
48 | ||
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ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS | 49 | |
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On August 3, 2005, the Company’s Audit Committee concluded that the Company will be required to restate its previously issued financial statements as of and for the years ended December 31, 2004, 2003 and 2002 and certain quarters during those years, and that these financial statements should not be relied upon.
The restatements for the periods mentioned relate to the accounting for the Company’s interest rate swaps, which were acquired between 2001 and 2003. These swaps had been accounted for under FAS 133, “Accounting for Derivative Instruments and Hedging Activities” until October 1, 2004, as if which date the Company had previously determined that the swaps no longer qualified for hedge accounting treatment. The effectiveness test that the Company used is known as the “shortcut method.” Management and the Audit Committee have recently concluded that this form of testing was not permitted under FAS 133 for prime rate indexed swaps from the inception of the Company’s swaps. Although the results of the testing using FAS 133 compliant testing and the results under the shortcut method show no difference in the effectiveness of the swaps, hedge accounting under FAS 133 was not allowed for the above stated periods. The restatements are expected to result in changes to reported income and expense. However, the Company expects that there will be no material effect on either the statements of financial condition or cash flows for any of the periods involved
The restatement financial information included in this filing has been restated as described. However, an independent public accountant has not completed a review of the financial statements in accordance with SEC rules. Therefore, the certifications of the Company's Chief Executive Officer and Chief Financial Officer required by SEC rules to be filed as exhibits to this report on Form 10-Q have not been included with this filing.
The restated financial information included in this filing is not reflected in any filings of prior 10Ks or 10Qs. The necessary amended 10Ks and 10Qs will be filed after audit and review are appropriately completed.
The purpose of the restatement is to eliminate hedge accounting for the interest rate swaps during the periods that the Company used the shortcut method of effectiveness testing. Hedge accounting allows a company to mark the swap contracts to market each month through the Other Comprehensive Earnings section of Shareholders’ Equity. Subsequently, the balance of Other Comprehensive Earnings for swaps is amortized against future net income. Eliminating hedge accounting reverses that treatment and recognizes the mark to market adjustment in current earnings.
The effect of the restatement on earnings for the affected periods is shown in the table included in the “Restatement” portion of Note 2 (“Basis of Presentation”) to the consolidated financial statements included herein.
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PART I - FINANCIAL INFORMATION
Item 1. | INTERIM CONSOLIDATED FINANCIAL STATEMENTS |
CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(Unaudited) | (Unaudited) Restated* | |||||||
06/30/2005 | 12/31/2004 | |||||||
(Dollars in thousands) | ||||||||
ASSETS | ||||||||
Cash and due from banks | $ | 84,618 | $ | 63,564 | ||||
Federal funds sold | 50,190 | 35,915 | ||||||
Money market funds and interest-bearing deposits in other banks | 3,564 | 3,663 | ||||||
Cash and cash equivalents | 138,372 | 103,142 | ||||||
Securities available for sale, at fair value | 189,149 | 157,027 | ||||||
Securities held to maturity, at amortized cost (fair value of $10,323 as of June 30, 2005 and $11,553 as of December 31, 2004) | 10,246 | 11,396 | ||||||
Federal Home Loan Bank and other equity stock, at cost | 5,321 | 3,905 | ||||||
Loans, net of allowance for loan losses of $12,538 as of June 30, 2005 and $11,227 as of December 31, 2004 | 1,091,260 | 995,950 | ||||||
Loans held for sale, at the lower of cost or market | 18,992 | 14,523 | ||||||
Premises and equipment, net | 12,947 | 11,695 | ||||||
Customers’ liability on acceptances | 4,221 | 8,505 | ||||||
Accrued interest receivable | 5,174 | 4,894 | ||||||
Deferred income taxes, net | 6,328 | 7,108 | ||||||
Investments in affordable housing partnerships | 3,700 | 3,857 | ||||||
Cash surrender value of life insurance | 10,615 | 10,430 | ||||||
Goodwill | 1,253 | 1,253 | ||||||
Intangible assets | 400 | 426 | ||||||
Other assets | 4,184 | 4,003 | ||||||
Total | $ | 1,502,162 | $ | 1,338,114 | ||||
LIABILITIES AND SHAREHOLDERS’ EQUITY | ||||||||
Liabilities: | ||||||||
Deposits: | ||||||||
Noninterest-bearing | $ | 387,183 | $ | 347,195 | ||||
Interest-bearing | 933,546 | 818,341 | ||||||
Total deposits | 1,320,729 | 1,165,536 | ||||||
Acceptances outstanding | 4,221 | 8,505 | ||||||
Accrued interest payable | 4,556 | 3,681 | ||||||
Other borrowed funds | 48,538 | 44,854 | ||||||
Long-term subordinated debentures | 18,557 | 18,557 | ||||||
Accrued expenses and other liabilities | 4,405 | 6,261 | ||||||
Total liabilities | 1,401,006 | 1,247,394 | ||||||
Commitments and Contingencies (Note 11) | ||||||||
Shareholders’ Equity | ||||||||
Serial preferred stock, no par value; authorized 10,000,000 shares; issued and outstanding, none | — | — | ||||||
Common stock, no par value; authorized 40,000,000 shares; issued and outstanding, 16,373,275 as of June 30, 2005 and 16,283,496 as of December 31, 2004 | 65,281 | 64,785 | ||||||
Retained earnings | 36,528 | 26,290 | ||||||
Accumulated other comprehensive income (loss), net of tax | (653 | ) | (355 | ) | ||||
Total shareholders’ equity | 101,156 | 90,720 | ||||||
Total | $ | 1,502,162 | $ | 1,338,114 | ||||
See accompanying notes to interim consolidated financial statements.
* | (See “Restatement” portion of Note 2) |
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CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2005 AND 2004 (Unaudited and Restated*)
Three Months Ended June 30, | Six Months Ended June 30, | ||||||||||||||
2005 | 2004 | 2005 | 2004 | ||||||||||||
(Dollars in thousands, except per share data) | |||||||||||||||
Interest and Dividend Income: | |||||||||||||||
Interest and fees on loans | $ | 20,068 | $ | 12,029 | $ | 37,813 | $ | 23,404 | |||||||
Interest on federal funds sold | 188 | 102 | 359 | 163 | |||||||||||
Interest on taxable investment securities | 1,422 | 754 | 2,703 | 1,652 | |||||||||||
Interest on tax-advantaged investment securities | 76 | 131 | 147 | 303 | |||||||||||
Dividends on equity stock | 54 | 37 | 87 | 62 | |||||||||||
Money market funds and interest-earning deposits | 27 | 71 | 50 | 102 | |||||||||||
Total interest and dividend income | 21,835 | 13,124 | 41,159 | 25,686 | |||||||||||
Interest Expense: | |||||||||||||||
Interest on deposits | 5,666 | 3,312 | 10,487 | 6,133 | |||||||||||
Interest on borrowed funds | 278 | 101 | 532 | 270 | |||||||||||
Interest on long-term subordinated debenture | 272 | 182 | 538 | 365 | |||||||||||
Total interest expense | 6,216 | 3,595 | 11,557 | 6,768 | |||||||||||
Net interest income before provision for loan losses | 15,619 | 9,529 | 29,602 | 18,918 | |||||||||||
Provision for loan losses | 1,050 | 600 | 1,700 | 1,450 | |||||||||||
Net interest income after provision for loan losses | 14,569 | 8,929 | 27,902 | 17,468 | |||||||||||
Noninterest Income: | |||||||||||||||
Customer service fees | 2,428 | 1,994 | 4,663 | 3,910 | |||||||||||
Fee income from trade finance transactions | 929 | 915 | 1,831 | 1,618 | |||||||||||
Wire transfer fees | 251 | 213 | 455 | 398 | |||||||||||
Gain on sale of loans | 592 | 890 | 1,265 | 1,267 | |||||||||||
Net (loss) gain on sale of securities available for sale | 1 | (6 | ) | 51 | (6 | ) | |||||||||
Loan service fees | 419 | 458 | 859 | 1,009 | |||||||||||
Other income | 394 | 426 | 927 | 779 | |||||||||||
Total noninterest income | 5,014 | 4,890 | 10,051 | 8,975 | |||||||||||
Noninterest Expense: | |||||||||||||||
Salaries and employee benefits | 4,532 | 3,675 | 8,977 | 7,357 | |||||||||||
Occupancy | 854 | 672 | 1,569 | 1,209 | |||||||||||
Furniture, fixtures, and equipment | 407 | 329 | 815 | 650 | |||||||||||
Data processing | 477 | 506 | 942 | 974 | |||||||||||
Professional service fees | 1,108 | 1,161 | 1,906 | 1,305 | |||||||||||
Business promotion and advertising | 666 | 604 | 1,316 | 925 | |||||||||||
Stationery and supplies | 236 | 127 | 413 | 233 | |||||||||||
Telecommunications | 170 | 157 | 299 | 283 | |||||||||||
Postage and courier service | 187 | 158 | 350 | 287 | |||||||||||
Security service | 197 | 167 | 372 | 322 | |||||||||||
Impairment loss of securities available for sale | — | — | — | 540 | |||||||||||
Loss on termination of interest rate swap | — | — | 306 | — | |||||||||||
(Gain) or Loss on Interest Rate Swaps: | |||||||||||||||
Swap Mark to Market | (231 | ) | 1,986 | 77 | 1,452 | ||||||||||
Swap Ineffectiveness | 6 | — | 6 | — | |||||||||||
Other operating expenses | 863 | 1,021 | 1,646 | 1,698 | |||||||||||
Total noninterest expense | 9,472 | 10,563 | 18,994 | 17,235 | |||||||||||
Income before income tax provision | 10,111 | 3,256 | 18,959 | 9,208 | |||||||||||
Income tax provision | 3,978 | 1,208 | 7,413 | 3,503 | |||||||||||
Net income | $ | 6,133 | $ | 2,048 | $ | 11,546 | $ | 5,705 | |||||||
Earnings per share: | |||||||||||||||
Basic | $ | 0.38 | $ | 0.13 | $ | 0.71 | $ | 0.36 | |||||||
Diluted | $ | 0.37 | $ | 0.12 | $ | 0.69 | $ | 0.35 |
See accompanying notes to consolidated interim financial statements.
* | (See “Restatement” portion of Note 2) |
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CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
SIX MONTHS ENDED JUNE 30, 2005 AND YEAR ENDED DECEMBER 31, 2004 (Unaudited and Restated*)
Common Stock | Retained Earnings | Accumulated Comprehensive | Total Shareholders’ | ||||||||||||||
Number of Shares | Amount | ||||||||||||||||
(Dollars and Share Numbers in thousands) | |||||||||||||||||
BALANCE, JANUARY 1, 2004 | 16,048 | $ | 63,438 | $ | 15,299 | $ | (476 | ) | $ | 78,261 | |||||||
Comprehensive income | |||||||||||||||||
Net income | 14,224 | 14,224 | |||||||||||||||
Other comprehensive income | |||||||||||||||||
Change in unrealized gain, net of tax expense (benefit) of $88: | |||||||||||||||||
Securities available for sale | 121 | 121 | |||||||||||||||
Interest rate swap | — | ||||||||||||||||
Comprehensive income | 14,345 | ||||||||||||||||
Stock options exercised | 235 | 933 | 933 | ||||||||||||||
Tax benefit from stock options exercised and acceleration of stock options | 414 | 414 | |||||||||||||||
Cash dividends ($0.20 per share) | — | — | (3,233 | ) | — | (3,233 | ) | ||||||||||
BALANCE, DECEMBER 31, 2004 | 16,283 | 64,785 | 26,290 | (355 | ) | 90,720 | |||||||||||
Comprehensive income | |||||||||||||||||
Net income | 11,546 | 11,546 | |||||||||||||||
Other comprehensive income | |||||||||||||||||
Change in unrealized gain, net of tax (benefit) expense of $(227) and $11 on: | |||||||||||||||||
Securities available for sale | (313 | ) | |||||||||||||||
Interest rate swap | 15 | (298 | ) | ||||||||||||||
Comprehensive income | 11,248 | ||||||||||||||||
Stock options exercised | 90 | 496 | 496 | ||||||||||||||
Cash dividends ($0.08 per share) | — | — | (1,308 | ) | — | (1,308 | ) | ||||||||||
BALANCE, JUNE 30, 2005 | 16,373 | $ | 65,281 | $ | 36,528 | $ | (653 | ) | $ | 101,156 | |||||||
See accompanying notes to interim consolidated financial statements.
* | (See “Restatement” portion of Note 2) |
(Continued)
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CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
SIX MONTHS ENDED JUNE 30, 2005 AND YEAR ENDED DECEMBER 31, 2004 (Unaudited and Restated*)
Disclosures of reclassification amounts for the six months ended June 30, 2005 and for the year ended December 31, 2004:
6/30/2005 | 12/31/2004 | |||||||
(Dollars in thousands) | ||||||||
Unrealized gain on securities available for sale: | ||||||||
Unrealized holding gain arising during period, net of tax expense (benefit) of $(205) in 2005 and $(870) in 2004 | $ | (283 | ) | $ | (1,199 | ) | ||
Less reclassification adjustments for gain included in net income, net of tax (benefit) expense of ($22) in 2005 and $958 in 2004 | (30 | ) | 1,320 | |||||
Net change in unrealized gain on securities available for sale, net of tax (benefit) expense of ($227) in 2005 and $88 in 2004 | (313 | ) | 121 | |||||
Unrealized gain on interest rate swap: | ||||||||
Unrealized holding gain arising during period, net of tax expense (benefit) of $11 in 2005 | 15 | — | ||||||
Net change in unrealized gain on interest rate swap | 15 | — | ||||||
Change in unrealized gain on securities available for sale and interest rate swap, net of tax | $ | (298 | ) | $ | 121 | |||
See accompanying notes to interim consolidated financial statements. | (Concluded) |
* | (See “Restatement” portion of Note 2) |
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CENTER FINANCIAL CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2005 AND 2004 (Unaudited and Restated*)
06/30/2005 | 06/30/2004 | |||||||
(Dollars in thousands) | ||||||||
Cash flows from operating activities: | ||||||||
Net income | $ | 11,546 | $ | 5,705 | ||||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
Depreciation and amortization | 761 | 672 | ||||||
Amortization of premium, net of accretion of discount, on securities available for sale and held to maturity | 30 | 288 | ||||||
Provision for loan losses | 1,700 | 1,450 | ||||||
Impairment of securities available for sale | — | 540 | ||||||
Net gain on disposal of premises and equipment | — | 99 | ||||||
Net (loss) gain on sale of securities available for sale | (51 | ) | 6 | |||||
Originations of SBA loans held for sale | (13,999 | ) | (10,717 | ) | ||||
Gain on sale of loans | (1,265 | ) | (1,267 | ) | ||||
Proceeds from sale of SBA loans | 38,086 | 22,113 | ||||||
Deferred tax provision | 1,024 | — | ||||||
Federal Home Loan Bank stock dividend | (77 | ) | (32 | ) | ||||
Increase in accrued interest receivable | (280 | ) | (409 | ) | ||||
Net increase in cash surrender value of life insurance policy | (185 | ) | (204 | ) | ||||
(Increase) decrease in other assets and servicing assets | (158 | ) | 428 | |||||
Increase in accrued interest payable | 875 | 272 | ||||||
Decrease in accrued expenses and other liabilities | (1,856 | ) | (2,536 | ) | ||||
Net cash provided by operating activities | 36,151 | 16,408 | ||||||
Cash flow from investing activities: | ||||||||
Purchase of securities available for sale | (93,062 | ) | (9,477 | ) | ||||
Proceeds from principal repayment, matured, or called securities available for sale | 46,905 | 14,066 | ||||||
Proceeds from sale of securities available for sale | 13,531 | 119 | ||||||
Proceeds from matured, called or principal repayment on securities held to maturity | 1,135 | 2,521 | ||||||
Purchase of Federal Home Loan Bank and other equity stock | (1,339 | ) | (1,216 | ) | ||||
Net increase in loans | (124,339 | ) | (156,208 | ) | ||||
Proceeds from recoveries of loans previously charged off | 38 | 468 | ||||||
Purchases of premises and equipment | (2,013 | ) | (862 | ) | ||||
Cash acquired from purchase of Chicago branch | — | 3,848 | ||||||
Net decrease (increase) in investments in affordable housing partnerships | 157 | (279 | ) | |||||
Net cash used in investing activities | (158,987 | ) | (147,020 | ) | ||||
Cash flow from financing activities: | ||||||||
Net increase in deposits | 155,194 | 181,128 | ||||||
Net increase (decrease) in other borrowed funds | 3,684 | (38,945 | ) | |||||
Proceeds from stock options exercised | 496 | 304 | ||||||
Payment of cash dividend | (1,308 | ) | (1,287 | ) | ||||
Net cash provided by financing activities | 158,066 | 141,200 | ||||||
Net increase (decrease) in cash and cash equivalents | 35,230 | 10,588 | ||||||
Cash and cash equivalents, beginning of year | 103,142 | 140,961 | ||||||
Cash and cash equivalents, end of year | $ | 138,372 | $ | 151,549 | ||||
Supplemental disclosure of cash flow information: | ||||||||
Interest paid | $ | 10,681 | $ | 6,457 | ||||
Income taxes paid | $ | 7,980 | $ | 5,217 |
See accompanying notes to consolidated financial statements.
* | (See “Restatement” portion of Note 2) |
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NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
1. THE BUSINESS OF CENTER FINANCIAL CORPORATION
The financial information included in this filing have been restated as hereinabove described. However, an independent public accountant has not completed a review of the financial statements in accordance with SEC rules. Therefore, the certifications of the Company’s Chief Executive Officer and Chief Financial Officer required by SEC rules to be filed as exhibits to this report Form 10-Q have not been included with this filing.
Center Financial Corporation (“Center Financial”) is a bank holding company headquartered in Los Angeles, California which was incorporated on April 19, 2000 and acquired all of the issued and outstanding shares of Center Bank (the “Bank”) in October 2002. Center Financial’s direct subsidiaries include the Bank and Center Capital Trust I. Center Capital Trust is a Delaware statutory business trust formed in December 2003 for the exclusive purpose of issuing and selling capital trust pass-through securities. Center Financial exists primarily for the purpose of holding the stock of the Bank and of other subsidiaries. Center Financial, the Bank, and the subsidiary of the Bank (“CB Capital Trust”) discussed below, are collectively referred to herein as the “Company.”
The Bank is a California state-chartered and FDIC-insured financial institution, which was incorporated in 1985 and commenced operations in March 1986. The Bank changed its name from California Center Bank to Center Bank in December 2002. The Bank’s headquarters is located at 3435 Wilshire Boulevard, Suite 700, Los Angeles, California 90010. The Bank is a community bank providing comprehensive financial services for small to medium sized business owners, mostly in Southern California. The Bank specializes in commercial loans, which are mostly secured by real property, to multi-ethnic and small business customers. In addition, the Bank is a Preferred Lender of Small Business Administration (“SBA”) loans and provides trade finance loans and other international banking products. The Bank’s primary market is the greater Los Angeles metropolitan area, including Orange, San Bernardino, and San Diego counties in California and Cook County in Illinois, primarily focused in areas with high concentrations of Korean-Americans. The Bank currently has sixteen full-service branch offices located in Los Angeles, Orange, San Bernardino, and San Diego counties in California, Cook County in Illinois and Seattle in Washington. The Bank opened 14 of its branches as de novo branches. On April 26, 2004, the Company completed its acquisition of the Korea Exchange Bank (KEB) Chicago branch in Cook County, Illinois, the Bank’s first out-of-state branch, which focuses on the Korean-American niche market in Chicago. The Company assumed $12.9 million in FDIC insured deposits and purchased $8.0 million in loans from the KEB Chicago branch. The Company opened its fifteenth and sixteenth branches in the San Fernando Valley, in Los Angeles, California and in Seattle, Washington on December 20, 2004 and May 5, 2005, respectively. The Bank also operates nine Loan Production Offices (“LPOs”) in Phoenix, Seattle, Denver, Washington D.C., Las Vegas, Atlanta, Honolulu, Houston and Dallas. During the third quarter of 2004, the Company opened LPOs in Atlanta and Honolulu. New LPOs in Houston and Dallas started operation in late October 2004. The Company has also obtained regulatory approvals to expand its branch network in Southern California with a new office in Irvine.
CB Capital Trust, a Maryland real estate investment trust, was formed as a subsidiary of the Bank in August 2002 with the primary business purpose of investing in the Bank’s real estate-related assets, which Management believes should raise capital and increase the Company’s total capital although no assurance can be given that this result will occur. CB Capital Trust was capitalized in September 2002, whereby the Bank exchanged real estate related assets for 100% of the common stock of CB Capital Trust.
Center Financial’s principal source of income is currently dividends from the Bank, but Center Financial intends to explore supplemental sources of income in the future. The expenditures of Center Financial, including the payment of dividends to shareholders, if and when declared by the Board of Directors, the cost of servicing debt, legal and accounting professional fees, and Nasdaq listing fees, have been and will generally be paid from dividends paid to Center Financial by the Bank.
2. BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Center Financial, the Bank, and CB Capital Trust. Intercompany transactions and accounts have been eliminated in consolidation. Center Capital Trust I is not consolidated as disclosed in Note 7.
The interim consolidated financial statements are presented in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The information furnished in these interim statements reflects all adjustments which are, in the opinion of Management, necessary for the fair statement of results for the periods presented. All adjustments are of a normal and recurring nature. Results for the three and six months ended June 30, 2005 are not necessarily indicative of the results which may be expected for any other interim period or for the year as a whole. Certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted. The unaudited consolidated financial statements should be read in conjunction with the audited financial statements and notes included in the Company’s annual report on Form 10-K for the year ended December 31, 2004.
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Certain reclassifications have been made to the prior period financial statements to conform to the current period presentation.
Restatement: On August 3, 2005, the Company’s Audit Committee concluded that the Company will be required to restate its previously issued financial statements as of and for the years ended December 31, 2004, 2003 and 2002 and certain quarters during those years, and that these financial statements should not be relied upon.
The restatements for the periods mentioned relate to the accounting for the Company’s interest rate swaps, which were acquired between 2001 and 2003. These swaps had been accounted for under FAS 133, “Accounting for Derivative Instruments and Hedging Activities” until October 1, 2004, as of which date the Company had previously determined that the swaps no longer qualified for hedge accounting treatment. The effectiveness test that the Company used is known as the “shortcut method.” Management and the Audit Committee have recently concluded that this form of testing was not permitted under FAS 133 for prime rate indexed swaps from the inception of the Company’s swaps. Although the results of the testing using FAS 133 compliant testing and the results under the shortcut method show no difference in the effectiveness of the swaps, hedge accounting under FAS 133 was not allowed for the above stated periods. The restatements are expected to result in changes to reported income and expense. However, the Company expects that there will be no material effect on either the statements of financial condition or cash flows for any of the periods involved
The financial information included in this filing has been restated as described. However, an independent public accountant has not completed a review of the financial statements in accordance with SEC rules. Therefore, the certifications of the Company’s Chief Executive Officer and Chief Financial Officer required by SEC rules to be filed as exhibits to this report Form 10-Q have not been included with this filing.
The restated financial information included in this filing is not reflected in any filings of prior 10Ks or 10Qs. The necessary amended 10Ks and 10Qs will be filed after audit and review are appropriately completed.
The purpose of the restatement is to eliminate hedge accounting for the interest rate swaps during the periods that the Company used the shortcut method to test effectiveness. Hedge accounting allows a company to record changes in the fair market value of swap contracts in the Other Comprehensive income component of Shareholders’ Equity. Eliminating hedge accounting requires change in the fair market value in interest rate swaps to be recorded in current earnings.
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The effect of the restatement on earnings for affected periods is shown in the following table. The restated figures in the following table are preliminary and may change following the review of the restated financial statements by the Company’s independent accountants.
Pre Tax | After Tax | |||||||||||||||
Pre Tax Swap Mark to Market | PreTax Income | % of Pre Tax Income | After Tax Swap Mark to Market | Net Income | % of Net Income | |||||||||||
Q401 | (192 | ) | 2,931 | (6.6 | %) | (111 | ) | 1,757 | (6.3 | %) | ||||||
2001 | (192 | ) | 12,106 | (1.6 | %) | (111 | ) | 7,760 | (1.4 | %) | ||||||
Q102 | 450 | 3,473 | 13.0 | % | 261 | 2,141 | 12.2 | % | ||||||||
Q202 | 233 | 3,130 | 7.4 | % | 135 | 1,914 | 7.0 | % | ||||||||
Q302 | 1,290 | 4,490 | 28.7 | % | 747 | 2,807 | 26.6 | % | ||||||||
Q402 | (236 | ) | 3,713 | (6.3 | %) | (137 | ) | 2,484 | (5.5 | %) | ||||||
2002 | 1,736 | 14,806 | 11.7 | % | 1,006 | 9,347 | 10.8 | % | ||||||||
Q103 | 1,080 | 4,007 | 26.9 | % | 626 | 2,525 | 24.8 | % | ||||||||
Q203 | 48 | 4,894 | 1.0 | % | 28 | 3,078 | 0.9 | % | ||||||||
Q303 | 382 | 4,671 | 8.2 | % | 222 | 3,005 | 7.4 | % | ||||||||
Q403 | (1,133 | ) | 4,777 | (23.7 | %) | (657 | ) | 3,043 | (21.6 | %) | ||||||
2003 | 376 | 18,348 | 2.1 | % | 218 | 11,652 | 1.9 | % | ||||||||
Q104 | 534 | 5,418 | 9.9 | % | 309 | 3,347 | 9.2 | % | ||||||||
Q204 | (1,986 | ) | 5,241 | (37.9 | %) | (1,151 | ) | 3,199 | (36.0 | %) | ||||||
Q304 | 249 | 6,654 | 3.7 | % | 144 | 4,103 | 3.5 | % | ||||||||
Q304 | 0 | 6,662 | n/a | 0 | 4,365 | n/a | ||||||||||
2004 | (1,204 | ) | 23,975 | (5.0 | %) | (698 | ) | 15,014 | (4.6 | %) | ||||||
3. SIGNIFICANT ACCOUNTING POLICIES
Accounting policies are fully described in Note 2 in Center Financial’s Annual Report on Form 10-K and there have been no material changes except as herein noted.
4. RECENT ACCOUNTING PRONOUNCEMENTS
In December 2003, the Accounting Standards Executive Committee of the AICPA issued Statement of Position No. 03-3 (“SOP 03-3”), Accounting for Certain Loans or Debt Securities Acquired in a Transfer . SOP 03-3 addresses the accounting for differences between contractual cash flows and the cash flows expected to be collected from purchased loans or debt securities if those differences are attributable, in part, to credit quality. SOP 03-3 requires purchased loans and debt securities to be recorded initially at fair value based on the present value of the cash flows expected to be collected with no carryover of any valuation allowance previously recognized by the seller. Interest income should be recognized based on the effective yield from the cash flows expected to be collected. To the extent that the purchased loans or debt securities experience subsequent deterioration in credit quality, a valuation allowance would be established for any additional cash flows that are not expected to be received. However, if more cash flows subsequently are expected to be received than originally estimated, the effective yield would be adjusted on a prospective basis. SOP 03-3 is effective for loans and debt securities acquired by the Company after December 15, 2004. Upon adoption on January 1, 2005, there was no impact on the Company’s financial position, results of operations, or cash flows.
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Management does not expect SOP 03-3 to have a material impact on our future financial position, results of operations, or cash flows.
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123R, Share-Based Payment. This Statement supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance, is a revision of SFAS No. 123, Accounting for Stock-Based Compensation and amends SFAS No. 95, Statement of Cash Flows . This revision of SFAS No. 123 eliminates the ability for public companies to measure share-based compensation transactions at the intrinsic value as allowed by APB Opinion No. 25, and requires that such transactions be accounted for based on the grant date fair value of the award. This Statement also amends SFAS No. 95, to require that excess tax benefits be reported as a financing cash inflow rather than as a reduction of taxes paid. Under the intrinsic value method allowed under APB Opinion No. 25, the difference between the quoted market price as of the date of the grant and the contractual purchase price of the share is charged to operations over the vesting period, and no compensation expense is recognized for fixed stock options with exercise prices equal to the market price of the stock on the dates of grant. Under the fair value based method as prescribed by SFAS No. 123R, the Company is required to charge the value of all newly granted stock-based compensation to expense over the vesting period based on the computed fair value on the grant date of the award. The Statement does not specify a valuation technique to be used to estimate the fair value but states that the use of option-pricing models such as a lattice model (i.e. a binomial model) or a closed-end model (i.e. the Black-Scholes model) would be acceptable. The revised accounting for stock-based compensation requirements must be adopted no later than the beginning of the first annual reporting period that begins after June 15, 2005.
The Company will adopt this Standard effective January 1, 2006, using the modified prospective method, recording compensation expense for all awards granted after the date of adoption and for the unvested portion of previously granted awards that remain outstanding at the date of adoption. Currently, the Company does not recognize compensation expense for stock-based compensation. Management does not anticipate that this will have a material effect on the Company’s results of operations, financial position or cash flows. Had the Company adopted SFAS No. 123R in prior periods, the impact on net income and earnings per share would have been similar to the pro forma net income and earnings per share in accordance with SFAS No. 123 as subsequently disclosed in Note 5.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, that addresses accounting for changes in accounting principle, changes in accounting estimates and changes required by an accounting pronouncement in the instance that the pronouncement does not include specific transition provisions and error correction. SFAS No. 154 requires retrospective application to prior periods’ financial statements of changes in accounting principle and error correction unless impracticable to do so. SFAS No. 154 states an exception to retrospective application when a change in accounting principle, or the method of applying it, may be inseparable from the effect of a change in accounting estimate. When a change in principle is inseparable from a change in estimate, such as depreciation, amortization or depletion, the change to the financial statements is to be presented in a prospective manner. SFAS No. 154 and the required disclosures are effective for accounting changes and error corrections in fiscal years beginning after December 15, 2005.
In June 2005, the FASB decided not to provide additional guidance on the meaning of other-than-temporary impairment, and directed the staff to issue proposed FASB Staff Position (“FSP”) Emerging Issues Task Force (“EITF”) 03-1-a, Implementation Guidance for the Application of Paragraph 16 of EITF Issue No. 03-1 , as final. The final FSP will supersede EITF Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments, and EITF Topic No. D-44, Recognition of Other-Than-Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair Value . The final FSP (retitled FSP FAS 115-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments ) will replace the guidance set forth in paragraphs 10-18 of EITF Issue 03-1 with references to existing other-than-temporary impairment guidance, such as SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, SEC Staff Accounting Bulletin No. 59, Accounting for Noncurrent Marketable Equity Securities, and APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. FSP FAS 115-1 will codify the guidance set forth in EITF Topic D-44 and clarify that an investor should recognize an impairment loss no later than when the impairment is deemed other than temporary, even if a decision to sell has not been made. FSP FAS 115-1 will be effective for other-than-temporary impairment analysis conducted in periods beginning after September 15, 2005. Adoption of this standard is not expected to have a significant impact on the Company’s stockholders’ equity.
5. STOCK BASED COMPENSATION
At June 30, 2005, the Company had stock-based employee compensation plans, which are described more fully in Note 14 to the Consolidated Financial Statements included in Center Financial’s Annual Report on Form 10-K. The Company applies the intrinsic value method as described in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,”
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and related interpretations in accounting for its plans. Accordingly, compensation cost is not recognized when the exercise price of an employee stock option equals or exceeds the fair market value of the stock on the date the option is granted. The following table presents the pro forma effects on net income and related earnings per share if compensation costs related to the stock option plans were measured using the fair value method as prescribed under SFAS No. 123, “Accounting for Stock-Based Compensation”:
For the Three Months Ended June 30, | For the Six Months Ended June 30, | |||||||||||
2005 | 2004 Restated* | 2005 | 2004 Restated* | |||||||||
(In thousands, except earnings per share) | ||||||||||||
Net income, as reported | $ | 6,133 | $ | 2,048 | $ | 11,546 | $ | 5,705 | ||||
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects | 134 | 91 | 282 | 170 | ||||||||
Pro forma net income | $ | 5,999 | $ | 1,957 | $ | 11,264 | $ | 5,535 | ||||
Earning per share | ||||||||||||
Basic - as reported | $ | 0.38 | $ | 0.13 | $ | 0.71 | $ | 0.35 | ||||
Basic - pro forma* | $ | 0.37 | $ | 0.12 | $ | 0.69 | $ | 0.34 | ||||
Diluted - as reported | $ | 0.37 | $ | 0.12 | $ | 0.69 | $ | 0.35 | ||||
Diluted - pro forma | $ | 0.36 | $ | 0.12 | $ | 0.68 | $ | 0.34 |
* | (See “Restatement” portion of Note 2 |
The fair value of the options granted was estimated using the Black-Scholes option-pricing model with the following assumptions:
Three Months Ended | Six Months Ended | |||||||||||
06/30/2005 | 06/30/2004 | 06/30/2005 | 06/30/2004 | |||||||||
Dividend Yield | 0.79 | % | 1.07 | % | 0.79 | % | 1.07 | |||||
Volatility | 30 | % | 30 | % | 30 | % | 30 | % | ||||
Risk-free interest rate | 3.8 | % | 3.3 | % | 3.8 | % | 3.3 | % | ||||
Expected life | 3-5 years | 3-5 years | 3-5 years | 3-5 years |
6. OTHER BORROWED FUNDS
The Company borrows funds from the Federal Home Loan Bank and the Treasury, Tax, and Loan Investment Program, which is administered by the Federal Reserve Bank. Borrowed funds totaled $48.5 million and $44.9 million at June 30, 2005 and December 31, 2004, respectively. Interest expense on total borrowed funds was $532,000 for the six months ended June 30, 2005, compared to $270,000 for the six months ended 2004, reflecting average interest rates of 3.10%, and 2.18%, respectively.
As of June 30, 2005, the Company borrowed $47.2 million from the Federal Home Loan Bank of San Francisco with overnight, term borrowing and 1 to 15 years note borrowings . Notes of 10-year and 15-year terms are amortizing at predetermined schedules over the life of the notes. The Company has pledged, under a blanket lien, all qualifying commercial and residential loans as collateral under the borrowing agreement with Federal Home Loan Bank, with a total carrying value of $700.0 million at June 30, 2005. During 2004, the Company started to participate in a new Blanket Lien Program with the FHLB in order to better utilize its borrowing capacity and use of its collateral. Under this program, the Company increased its collateral in order to increase its borrowing capacity as well as create a new liquidity source for future use. Total interest expense on the notes was $517,000 and $265,000 for the six months ended June 30, 2005, and 2004, respectively, reflecting average interest rates of 3.12% and 2.27% respectively.
Federal Home Loan Bank advances outstanding as of June 30, 2005 mature as follows:
2005 | 2007 | 2012 | 2017 | Total | ||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||||
Borrowings | $ | 40,000 | $ | 4,000 | $ | 1,516 | $ | 1,733 | $ | 47,249 | ||||||||||
Weighted interest rate | 3.45 | % | 4.08 | % | 4.58 | % | 5.24 | % | 3.60 | % |
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Borrowings obtained from the Treasury, Tax, and Loan Investment Program mature within a month from the transaction date. Under the program, the Company receives funds from the U.S. Treasury Department in the form of open-ended notes, up to a total of $2.2 million. The Company has pledged U.S. government agencies and/or mortgage-backed securities with a total carrying value of $3.4 million at June 30, 2005, as collateral to participate in the program. The total borrowed amount under the program, outstanding at June 30, 2005 and December 31, 2004 was $1.2 million and $2.2 million, respectively. Interest expense on notes was $11,200 and $4,500 for the six months ended June 30, 2005 and 2004, respectively, reflecting average interest rates of 2.45% and 0.76% respectively. In addition, the Company had customer deposits for tax payments which amounted to $113,000 and $268,000 at June 30, 2005 and December 31, 2004, respectively.
7. LONG-TERM SUBORDINATED DEBENTURE
The Company established Center Capital Trust I in December 2003 (the “Trust”) as a statutory business trust, which is a wholly owned subsidiary of the Company. In the private placement transaction, the Trust issued $18 million of floating rate (3-month LIBOR plus 2.85%) capital securities representing undivided preferred beneficial interests in the assets of the Trust. The Company is the owner of all the beneficial interests represented by the common securities of the Trust. The purpose of issuing the capital securities was to provide the Company with a cost-effective means of obtaining Tier I Capital for regulatory purposes. Effective December 31, 2003, as a consequence of adopting the provisions of FIN No. 46R, the Trust has never been consolidated into the accounts of the Company. Long term subordinated debt represents liabilities of the Company to the Trust.
On March 1, 2005, the FRB adopted a final rule that allows the continued inclusion of trust preferred securities in the Tier I capital of bank holding companies. However, under the final rule, after a five-year transition period, the aggregate amount of trust preferred securities and certain other capital elements would be limited to 25 percent of Tier I capital elements, net of goodwill. Trust preferred securities currently make up 15.3% of the Company’s Tier I capital
8. EARNINGS PER SHARE
The actual number of shares outstanding at June 30, 2005, was 16,373,275. Basic earnings per share is calculated on the basis of the weighted average number of shares outstanding during the period. Diluted earnings per share is calculated on the basis of weighted average shares outstanding during the period plus shares issuable upon assumed exercise of outstanding common stock options.
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The following table sets forth the Company’s earnings per share calculation for the three and six months ended June 30, 2005 and 2004:
For the Three Months Ended June 30, | ||||||||||||||||||
2005 | 2004 Restated* | |||||||||||||||||
(In thousands, except earnings per share) | ||||||||||||||||||
Net Income | Average Number of Shares | Per Share Amounts | Net Income | Average Number of Shares | Per Share Amounts | |||||||||||||
Basic earnings per share | $ | 6,133 | 16,356 | $ | 0.38 | $ | 2,048 | 16,092 | $ | 0.13 | ||||||||
Effect of dilutive securities: | ||||||||||||||||||
Stock options | — | 321 | (0.01 | ) | — | 517 | (0.01 | ) | ||||||||||
Diluted earnings per share* | $ | 6,133 | 16,677 | $ | 0.37 | $ | 2,048 | 16,609 | $ | 0.12 | ||||||||
* | (See “Restatement” portion of Note 2) |
For the Six Months Ended June 30, | ||||||||||||||||||
2005 | 2004 Restated* | |||||||||||||||||
(In thousands, except earnings per share) | ||||||||||||||||||
Net Income | Average Number of Shares | Per Share Amounts | Net Income | Average Number of Shares | Per Share Amounts | |||||||||||||
Basic earnings per share | $ | 11,546 | 16,336 | $ | 0.71 | $ | 5,705 | 16,070 | $ | 0.36 | ||||||||
Effect of dilutive securities: | ||||||||||||||||||
Stock options | — | 334 | (0.02 | ) | — | 403 | (0.01 | ) | ||||||||||
Diluted earnings per share | $ | 11,546 | 16,670 | $ | 0.69 | $ | 5,705 | 16,473 | $ | 0.35 | ||||||||
* | (See “Restatement” portion of Note 2) |
9. CASH DIVIDENDS
On March 16, 2005, the Board of Directors declared a quarterly cash dividend of 4 cents per share. This cash dividend was paid on April 14, 2005 to shareholders of record as of March 31, 2005.
On June 24, 2005, the Board of Directors declared a quarterly cash dividend of 4 cents per share. This cash dividend was paid on July 25 2005, to shareholders of record as of July 8, 2005.
10. GOODWILL AND INTANGIBLES
In July 2001, the FASB issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations completed after June 30, 2001 and also specifies the types of acquired intangible assets that are required to be recognized and reported separately from goodwill and those acquired intangible assets that are required to be included in goodwill. SFAS No. 142 requires that goodwill no longer be amortized, but instead be tested for impairment at least annually. Additionally, SFAS No. 142 requires recognized intangible assets to be amortized over their respective estimated useful lives and reviewed for impairment. The Company adopted SFAS No. 142 on January 1, 2002.
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In April 2004, the Company purchased the Chicago branch of Korea Exchange Bank and recorded goodwill of $1.3 million and a core deposit intangible of $462,000. The Company amortizes premiums on acquired deposits using the straight-line method over 5 to 9 years. Accumulated amortization expense for core deposit intangible was $62,000, and the core deposit intangible balance net of amortization was $400,000 at June 30, 2005. Estimated amortization expense for core deposit intangible for five succeeding fiscal years and thereafter are as follows:
Estimated amortization expense for core deposit intangible for the remainder of 2005 and five succeeding fiscal years as follows:
Dollars in thousands | |||
2005 (remaining six months) | $ | 27 | |
2006 | 53 | ||
2007 | 53 | ||
2008 | 53 | ||
2009 | 54 | ||
2010 thereafter | 160 |
11. COMMITMENTS AND CONTINGENCIES
The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, commercial letters of credit, standby letters of credit, and performance bonds. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.
The Company’s exposure to credit loss is represented by the contractual notional amount of these instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Commitments to extend credit are agreements to lend to a customer provided there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since certain of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of the collateral obtained, if deemed necessary by the Company upon extension of credit, is based on Management’s credit evaluation of the borrower.
Commercial letters of credit, standby letters of credit, and performance bonds are conditional commitments 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 making loans to customers. The Company generally holds collateral supporting those commitments if deemed necessary.
A summary of the notional amounts of the Company’s financial instruments relating to extension of credit with off-balance-sheet risk at June 30, 2005 and December 31, 2004 follows:
Outstanding Commitments (Dollars in thousands)
June 30, 2005 | December 31, 2004 | |||||
Loans | $ | 207,736 | $ | 171,660 | ||
Standby letters of credit | 12,378 | 11,929 | ||||
Performance bonds | 284 | 132 | ||||
Commercial letters of credit | 28,994 | 22,150 |
12. DERIVATIVE FINANCIAL INSTRUMENTS
This note should be read in junction with the “Restatement” portion of Note 2 above (“Basis of Presentation”). The Company has identified certain variable-rate loans as a source of interest rate risk to be hedged in connection with the Company’s overall asset-liability management process. As these loans have contractually variable rates, there is a risk of fluctuation in interest income as interest rates rise and fall in future periods. In response to this identified risk, the Company uses interest rate swaps as a cash flow hedge to mitigate the interest rate risk associated with the cash flows of the specifically identified variable-rate loans.
The Company’s interest rate swaps did not qualify for the use of the accounting treatment known as hedge accounting until the second quarter of 2005. There are two general components of accounting for the hedge instruments when hedge accounting is not used. First, the settlement payments involved in the hedge contracts are recorded in current income as Interest and Fees on Loans to reflect the impact of the contracts on the hedged assets. Second, the change in the market value of the hedge contracts is recorded in current income as gain or loss on interest rate swaps.
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In the second quarter 2005, the Company implemented the procedures necessary to qualify for hedge accounting. Under this method of accounting the settlement payments involved in the hedge contracts are recorded in current income as Interest and Fees on Loans to reflect the impact of the contracts on the hedged assets as it was under the previously employed accounting method. The second component, consisting of the change in the market value of the hedge contract, is recorded in Other Comprehensive Income in the period of change, and aggregated in Accumulated Other Comprehensive Income, a separate component of shareholders’ equity, net of tax, while ineffective portions are recognized in current earnings.
Under both methods used by the Company, revenues or expenses associated with the interest rate swap are accounted for on an accrual basis and are recognized as adjustments to interest income on loans, based on the interest rates currently in effect for the interest rate swap agreements.
The following table provides information as of June 30, 2005, on Company’s outstanding derivatives:
Description | Notional Value | Period | Fixed Receiving Rate | Floating Paying Rate | |||||||
(Dollars in thousands) | |||||||||||
Interest Rate Swap II | $ | 25,000 | 08/02-08/06 | 6.25 | % | WSJ Prime | * | ||||
Interest Rate Swap III | $ | 20,000 | 12/02-12/05 | 5.51 | % | WSJ Prime | * |
(*) | At June 30, 2005, the Wall Street Journal published Prime Rate was 6.25 percent |
The Company has entered into interest rate swaps to hedge the interest rate risk associated with the cash flows of specifically identified variable-rate loans. As of June 30, 2005, the Company had two interest rate swap agreements with a total notional amount of $45 million. One swap with notional value of a $20 million matured in May 2005. In February 2005, the Company terminated a $20 million notional amount interest rate swap with a loss of $306,000.
Settlement payments involved in the hedge contracts recorded in net interest income was $25,000 for the six months ended June 30, 2005, respectively as compared to $475,000 for the corresponding periods of last year. Change in the market value of the hedge contracts recorded in current income as gain or loss on interest rate swaps during the first quarter 2005 (when hedge accounting was not used) and for the six months ended June 30, 2005 was $77,000 compared to $1.4 million during the six months ended June 30, 2004 when hedge accounting was not used. During the second quarter 2005 hedge accounting was used, therefore the change in the market value of the hedge contracts of $26,000 is recorded in a separate component of shareholders’ equity, net of tax, while the ineffective loss of $6,000 is recognized in current earnings.
The credit risk associated with the interest rate swap agreements represents the accounting loss that would be recognized at the reporting date if the counterparty failed completely to perform as contracted and any collateral or security proved to be of no value. To reduce such credit risk, the Company evaluates the counterparty’s credit rating and financial position. In Management’s opinion, the Company did not have a significant exposure to an individual counterparty before the maturity of the interest rate swap agreements, because the counterparties to the interest rate swap agreements are large banks with strong credit ratings.
13. BUSINESS SEGMENTS
Management utilizes an internal reporting system to measure the performance of the Company’s various operating segments. Management has identified three principal operating segments for purposes of management reporting: banking operations, trade finance (“TFS”), and small business administration (“SBA”). Information related to the remaining centralized functions and eliminations of inter-segment amounts have been aggregated and included in banking operations. Although all three operating segments offer financial products and services, they are managed separately based on each segment’s strategic focus. The banking operation segment focuses primarily on commercial and consumer lending and deposit operations throughout the branch network. The TFS segment allows import/export customers to handle their international transactions. Trade finance products include the issuance and collection of letters of credit, international collection, and import/export financing. The SBA segment provides our customers with the U.S. SBA guaranteed lending program.
Operating segment results are based on the internal management reporting process, which reflects assignments and allocations of capital, certain operating and administrative costs and the provision for loan losses. Net interest income is based on the internal funds transfer pricing system which assigns a cost of funds or a credit for funds to assets or liabilities based on their type, maturity or repricing characteristics. Noninterest income and noninterest expense, including depreciation and amortization, directly attributable to a segment are assigned to that business. The Company allocates indirect costs, including overhead expense, to the
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various segments based on several factors, including, but not limited to, full-time equivalent employees, loan volume and deposit volume. The Company allocates the provision for loan losses based on new loan originations for the period. Management evaluates overall performance based on profit or loss from operations before income taxes not including nonrecurring gains and losses.
Future changes in the management structure or reporting methodologies may result in changes in the measurement of operating segment results. Results for prior periods have been restated for comparability for changes in management structure or reporting methodologies.
The following tables present the operating results and other key financial measures for the individual operating segments for the three and six months ended June 30, 2005 and 2004.
Three Months Ended June 30, 2005 | |||||||||||||
(Dollars in thousands) | |||||||||||||
Banking Operations | TFS | SBA | Total | ||||||||||
Interest income | $ | 18,127 | $ | 1,618 | $ | 2,090 | $ | 21,835 | |||||
Interest expense | 5,297 | 378 | 541 | 6,216 | |||||||||
Net interest income | 12,830 | 1,240 | 1,549 | 15,619 | |||||||||
Provision for loan losses | 883 | 151 | 16 | 1,050 | |||||||||
Net interest income after provision for loan losses | 11,947 | 1,089 | 1,533 | 14,569 | |||||||||
Other operating income | 3,234 | 1,037 | 743 | 5,014 | |||||||||
Other operating expenses | 8,383 | 733 | 356 | 9,472 | |||||||||
Segment pretax profit | $ | 6,798 | $ | 1,393 | $ | 1,920 | $ | 10,111 | |||||
Segment assets | $ | 1,304,816 | $ | 108,681 | $ | 88,665 | $ | 1,502,162 | |||||
Three Months Ended June 30, 2004 | |||||||||||||
(Dollars in thousands) | |||||||||||||
Banking Operations | TFS | SBA | Total | ||||||||||
Interest income | $ | 10,323 | $ | 1,317 | $ | 1,484 | $ | 13,124 | |||||
Interest expense | 3,005 | 310 | 280 | 3,595 | |||||||||
Net interest income | 7,318 | 1,007 | 1,204 | 9,529 | |||||||||
Provision for loan losses | 531 | 77 | (8 | ) | 600 | ||||||||
Net interest income after provision for loan losses | 6,787 | 930 | 1,212 | 8,929 | |||||||||
Other operating income | 2,681 | 1,013 | 1,196 | 4,890 | |||||||||
Other operating expenses | 7,420 | 722 | 435 | 8,577 | |||||||||
Segment pretax profit | $ | 2,048 | $ | 1,221 | $ | 1,973 | $ | 5,242 | |||||
Segment assets | $ | 956,973 | $ | 120,484 | $ | 108,520 | $ | 1,185,977 | |||||
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Six Months Ended June 30, 2005 (Dollars in thousands) | ||||||||||||||
Banking Operations | TFS | SBA | Total | |||||||||||
Interest income | $ | 34,441 | $ | 3,186 | $ | 3,532 | $ | 41,159 | ||||||
Interest expense | 9,752 | 761 | 1,044 | 11,557 | ||||||||||
Net interest income | 24,689 | 2,425 | 2,488 | 29,602 | ||||||||||
Provision for loan losses | 1,757 | (14 | ) | (43 | ) | 1,700 | ||||||||
Net interest income after provision for loan losses | 22,932 | 2,439 | 2,531 | 27,902 | ||||||||||
Other operating income | 6,444 | 2,168 | 1,439 | 10,051 | ||||||||||
Other operating expenses | 16,747 | 1,510 | 737 | 18,994 | ||||||||||
Segment pretax profit | $ | 12,630 | $ | 3,097 | $ | 3,233 | $ | 18,959 | ||||||
Segment assets | $ | 1,304,816 | $ | 108,681 | $ | 88,665 | $ | 1,502,162 | ||||||
Six Months Ended June 30, 2004 (Dollars in thousands) | ||||||||||||||
Banking Operations | TFS | SBA | Total | |||||||||||
Interest income | $ | 20,032 | $ | 2,639 | $ | 3,015 | $ | 25,686 | ||||||
Interest expense | 5,619 | 602 | 547 | 6,768 | ||||||||||
Net interest income | 14,413 | 2,037 | 2,468 | 18,918 | ||||||||||
Provision for loan losses | 1,127 | 242 | 81 | 1,450 | ||||||||||
Net interest income after provision for loan losses | 13,286 | 1,795 | 2,387 | 17,468 | ||||||||||
Other operating income | 5,363 | 1,807 | 1,805 | 8,975 | ||||||||||
Other operating expenses | 15,015 | 1,395 | 825 | 17,235 | ||||||||||
Segment pretax profit | $ | 3,634 | $ | 2,207 | $ | 3,367 | $ | 9,208 | ||||||
Segment assets | $ | 956,973 | $ | 120,484 | $ | 108,520 | $ | 1,185,977 | ||||||
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Item 2: | MANAGEMENT’S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
On August 3, 2005, the Company’s Audit Committee concluded that the Company will be required to restate its previously issued financial statements as of and for the years ended December 31, 2004, 2003 and 2002 and certain quarters during those years, and that these financial statements should not be relied upon.
The restatements for the periods mentioned relate to the accounting for the Company’s interest rate swaps, which were acquired between 2001 and 2003. These swaps had been accounted for under FAS 133, “Accounting for Derivative Instruments and Hedging Activities” until October 1, 2004, as of which date the Company had previously determined that the swaps no longer qualified for hedge accounting treatment. The effectiveness test that the Company used is known as the “shortcut method.” Management and the Audit Committee have recently concluded that this form of testing was not permitted under FAS 133 for prime rate indexed swaps from the inception of the Company’s swaps. Although the results of the testing using FAS 133 compliant testing and the results under the shortcut method show no difference in the effectiveness of the swaps, hedge accounting under FAS 133 was not allowed for the above stated periods. The restatements are expected to result in changes to reported income and expense. However, the Company expects that there will be no material effect on either the statements of financial condition or cash flows for any of the periods involved
The restatement financial information included in this filing have been restated as described. However, an independent public accountant has not completed a review of the financial statements in accordance with SEC rules. Therefore, the certifications of the Company’s Chief Executive Officer and Chief Financial Officer required by SEC rules to be filed as exhibits to this report Form 10-Q have not been included with this filing.
The restated financial information included in this filing is not reflected in any filings of prior 10Ks or 10Qs. The necessary amended 10Ks and 10Qs will be filed after audit and review are appropriately completed.
The purpose of the restatement is to eliminate hedge accounting for the interest rate swaps during the periods that the Company used the shortcut method of effectiveness testing. Hedge accounting allows a company to mark the swap contracts to market each month through the Other Comprehensive Earnings section of Shareholders’ Equity. Subsequently, the balance of Other Comprehensive Earnings for swaps is amortized against future net income. Eliminating hedge accounting reverses that treatment and recognizes the mark to market adjustment in current earnings.
The following is management’s discussion and analysis of the major factors that influenced our consolidated results of operations and financial condition for the three and six months ended June 30, 2005. This analysis should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2004 and with the unaudited consolidated financial statements and notes as set forth in this report. As indicated above, the Company is in the process of amending its Form 10-K for the fiscal year ended December 31, 2004, as well as certain other prior filings, and the financial statements contained therein can no longer be relied upon. All restated financial information for prior periods contained in this report is preliminary and may change following the review of the restated financial statements by the Company’s independent accountants.
Certain matters discussed under this caption may constitute forward-looking statements under Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934. There can be no assurance that the results described or implied in such forward-looking statements will, in fact, be achieved and actual results, performance, and achievements could differ materially because the business of the Company involves inherent risks and uncertainties. Risks and uncertainties include possible future deteriorating economic conditions in the Company’s areas of operation; interest rate risk associated with volatile interest rates and related asset-liability matching risk; liquidity risks; risk of significant non-earning assets, and net credit losses that could occur, particularly in times of weak economic conditions or times of rising interest rates; risks of available-for-sale securities declining significantly in value as interest rates rise or issuer’s of such securities suffering financial losses; and regulatory risks associated with the variety of current and future regulations to which the Company is subject. All of these risks could have a material adverse impact on the Company’s financial condition, results of operations or prospects, and these risks should be considered in evaluating the Company. For additional information concerning these factors, see “Interest Rate Risk Management” and “Liquidity and Capital Resources” contained in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section of our Form 10-K for the year ended December 31, 2004.
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Critical Accounting Policies
The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information contained within these statements is, to a significant extent, financial information that is based on approximate measures of the financial effects of transactions and events that have already occurred. Critical accounting policies are those that involve the most complex and subjective decisions and assessments and have the greatest potential impact on the Company’s results of operation. Management has identified its most critical accounting policies to be those relating to the following: investment securities, loan sales, allowance for loan losses, and interest rate swaps. The following is a summary of these accounting policies. In each area, we have identified the variables most important in the estimation process. We have used the best information available to make the estimations necessary to value the related assets and liabilities. Actual performance that differs from our estimates and future changes in the key variables could change future valuations and impact net income.
Investment Securities
Under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, investment securities generally must be classified as held-to-maturity, available-for-sale or trading. The appropriate classification is based partially on our ability to hold the securities to maturity and largely on management’s intentions with respect to either holding or selling the securities. The classification of investment securities is significant since it directly impacts the accounting for unrealized gains and losses on securities. Unrealized gains and losses on trading securities flow directly through earnings during the periods in which they arise, whereas for available-for-sale securities, they are recorded as a separate component of stockholders’ equity (accumulated comprehensive other income or loss) and do not affect earnings until realized. The fair values of our investment securities are generally determined by reference to quoted market prices and reliable independent sources. We are obligated to assess, at each reporting date, whether there is an “other-than-temporary” impairment to our investment securities. Such impairment must be recognized in current earnings rather than in other comprehensive income. Aside from the Fannie Mae and Freddie Mac preferred stocks that were determined to be impaired and written down during the twelve months of 2004, we did not have any other investment securities that were deemed to be “other-than-temporarily” impaired as of December 31, 2004. Investment securities are discussed in more detail in Note 3 to the consolidated financial statements presented elsewhere herein.
Loan Sales
Certain Small Business Administration (“SBA”) loans that we have the intent to sell prior to maturity are designated as held for sale at origination and are recorded at the lower of cost or market value, on an aggregate basis. A valuation allowance is established if the market value of such loans is lower than their cost, and operations are charged or credited for valuation adjustments. A portion of the premium on sale of SBA loans is recognized as other operating income at the time of the sale. The remaining portion of the premium (relating to the portion of the loan retained) is deferred and amortized over the remaining life of the loan as an adjustment to yield. Servicing assets are recognized when loans are sold with servicing retained. Servicing assets are recorded based on the present value of the contractually specified servicing fee, net of servicing costs, over the estimated life of the loan, using a discount rate based on the related note rate plus 2 %. Servicing assets are amortized in proportion to and over the period of estimated future servicing income. Management periodically evaluates the servicing asset for impairment, which is the carrying amount of the servicing asset in excess of the related fair value. Impairment, if it occurs, is recognized in a write down or charge-off in the period of impairment.
Allowance for Loan Losses
Our allowance for loan loss methodologies incorporate a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan loss that management believes is appropriate at each reporting date. Quantitative factors include our historical loss experience, delinquency and charge-off trends, collateral values, changes in nonperforming loans, and other factors. Quantitative factors also incorporate known information about individual loans, including borrowers’ sensitivity to interest rate movements and borrowers’ sensitivity to quantifiable external factors including commodity and finished good prices as well as acts of nature (earthquakes, floods, fires, etc.) that occur in a particular period. Qualitative factors include the general economic environment in our markets and, in particular, the state of certain industries. Size and complexity of individual credits, loan structure, extent and nature of waivers of existing loan policies and pace of portfolio growth are other qualitative factors that are considered in our methodologies. As we add new products, increase the complexity of our loan portfolio, and expand our geographic coverage, we will enhance our methodologies to keep pace with the size and complexity of the loan portfolio. Changes in any of the above factors could have significant impact to the loan loss calculation. We believe that our methodologies continue to be appropriate given our size and level of complexity. Detailed information concerning our loan loss methodology is contained in “Item 2, Management Discussion and Analysis of Financial Condition and Results of Operations- Allowance for Loan Losses.”
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Interest Rate Swaps
This discussion should be read in junction with the “Restatement portion of Note 2 (“Basis of Presentation”) to the consolidated financial statements contained herein.As part of our asset and liability management strategy, we have entered into derivative financial instruments, such as interest rate swaps. The objective for the interest rate swaps is to manage asset and liability positions in connection with our strategy of minimizing the interest rate fluctuations on interest rate margin and equity. The interest rate swaps are considered to be cash flow hedges under Statement of Financial Accounting Standards (“SFAS”) No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted, and are designated as hedges of the variability of cash flows we receive from certain of our Prime-indexed loans. In accordance with SFAS No. 133, these interest rate swap agreements are measured at fair value and reported as assets or liabilities on the consolidated statement of financial condition.
If such swaps qualify for hedge accounting treatment, then the change in the fair value of the swaps is recorded as a component of other comprehensive income (“OCI”), net of tax, in the period of change. The net cumulative total of gains and losses are aggregated in accumulated other comprehensive income. The amounts are reclassified into interest income as such cash flows occur in the future. However, if the swaps do not qualify for hedge accounting treatment, then the change in the fair value of the swaps is recorded as a gain or loss directly to the consolidated statement of earnings as a part of non-interest expense or income, as applicable. Currently, fair value of the interest rate swaps is estimated by discounting the future cash flows based on the current market yield curve using a standard swap valuation model.
The Company’s interest rate swaps did not qualify for hedge accounting treatment until the second quarter of 2005 to account for the derivative instruments.
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Executive Overview
This discussion should be read in junction with the “Restatement portion of Note 2 (“Basis of Presentation”) to the consolidated financial statements contained herein. Helped by continuing rate hikes and moderate growth in loans, the Company reported another record income for the second quarter of 2005. Consolidated net income for the second quarter of 2005 grew 199%, of which about 90% reflected increases from operating earnings, and the other 109% resulted from the effect of the accounting treatment of the Company’s interest rate swaps, as restated. Consolidated net income for the second quarter of 2005 was $6.1 million, or $0.37 per diluted share compared to $2.0 million or $0.12 per diluted share ($3.2 million or $0.20 per diluted share) in the second quarter of 2004. Consolidated net income in the second quarter of 2004 includes the pre-tax mark to market loss for interest rate swaps of $2.0 million. Before restatement this loss was included in Other Comprehensive Earnings net of taxes and did not affect current earnings. The fluctuation noted above is in part due to this change in accounting methods.
Consolidated net income for the first half of 2005 was $11.5 million, an increase of 102%, (77% without the effect of the swaps) or $0.69 per diluted share ($6.5 million and $0.40 per diluted share without the effect of the swaps) compared to $5.7 million or $0.35 per diluted share in the first half of 2004. The following were highlights related to the second quarter and first half of 2005 results as compared to comparable periods in 2004:
• | Management recently determined that the method of evaluating the effectiveness of the hedges used in 2002 through 2004 did not meet the technical requirements necessary to qualify for the hedge accounting treatment utilized during those periods. As a result, the Company has decided to restate its results from 2002 through 2004 with respect to the reporting of gains and losses due to changes in the fair market values of its interest rate swaps |
• | Our revenue increased by 49% to $26.8 million in the second quarter of 2005 versus 2004. For the first half of 2005, our revenue also increased by 48% to $51.2 million. |
• | Net interest income after provision for loan losses increased 63% to $14.6 million in second quarter. For the six months ended June 30, 2005 net interest income after provision for loan losses increased by 60% to $27.9 million. These increases were mainly due to the market rate hikes and loan growth. |
• | Fueled by market rate hikes, our net interest margin increased to 4.92% and 4.77% in the second quarter and first half of 2005, respectively, as compared to 3.73% and 3.87% in the comparable periods of 2004. |
• | Mainly contributed by an increased customer base as a result of geographical growth, our noninterest income grew by $124,000 or 3% in the second quarter of 2005, compared with same period in 2004. Noninterest income for the first half of 2005 was up by 12% to $10.1 million. |
• | Due to mark to market losses on interest rate swaps for the previous period, offset by increases in labor costs, noninterest expense decreased by $1.1 million during the second quarter of 2005. The increased hiring activity of highly qualified personnel due to geographical expansion was a major contributor to the increase in noninterest expense during the second quarter of 2005. |
• | We increased our provision for loan losses by $1.1 million during the second quarter of 2005 as compared to $600,000 for the same period of 2004. The increase in the provision was primarily due to growth in the commercial business loans and commercial real estate loan portfolios. |
• | Total deposits increased by 13% during the first half of 2005. The most significant increase in deposits since December 31, 2004 was an $81.1 million increase in time deposits over $100,000. This increase in time deposits over $100,000 was partially due to a new product offered by the Company with flexible rates to attract new deposits. Non-interest bearing demand deposits also increased by 12% to $387.2 million during the first half of 2005. |
Our financial condition and liquidity remain strong. The following are important factors in understanding our financial condition and liquidity:
• | We continued our geographical expansion by opening a new full service branch in Seattle in May 2005. |
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• | During the first half of 2005, we have experienced moderate loan growth in commercial real estate loans, commercial business loans and consumer loans. At June 30, 2005, our total gross loan portfolio increased by 10%, to $1.1 billion as compared to $1.0 billion at December 31, 2004. |
• | Our total assets continued to grow and reached $1.5 billion at June 30, 2005, an increase of 12% over December 31, 2004. |
• | Despite the loan growth, our ratio of non-accrual loans to total loans decreased to 0.27% at June 30, 2005 as compared to 0.34% at December 31, 2004. Our ratio of the allowance for loan losses to total nonperforming loans significantly increased to 414% at June 30, 2005, as compared to 327% at December 31, 2004. |
• | Under the regulatory framework for prompt corrective action, we continue to be “well-capitalized”. |
• | The Company declared its quarterly cash dividend of $0.04 per share on June 24, 2005. |
As previously noted and reflected in the Consolidated Statements of Operations, during the second quarter and for the six months ended June 30, 2005 the Company generated record net income of $6.1 million and $11.5 million, respectively, as compared to $2.0 million and $5.7 million (as restated to reflect losses on the Company’s interest rate swaps) for the same periods in 2004. The Company earns income from two primary sources: net interest income, which is the difference between interest income generated from the successful deployment of earning assets and interest expense created by interest-bearing liabilities; and net noninterest income, which is basically fees and charges earned from customer services less the operating costs associated with providing a full range of banking services to customers.
Net Interest Income and Net Interest Margin
The Company’s net interest income depends on the yields, volumes, and mix of its earning asset components, as well as the rates, volume, and mix associated with its funding sources. The Company’s net interest margin is its taxable-equivalent net interest income expressed as a percentage of its average earning assets.
Total interest and dividend income for the second quarter of 2005 increased 66% to $21.8 million compared with $13.1 million for the same period in 2004, primarily due to continuing market rate hikes and loan growth. Growth was driven by an increase in average net loans and average investment securities. Average net loans increased $225.4 million or 27% and average investment securities increased $59.3 million or 53% for the second quarter of 2005 compared to the same period in 2004. The Company invested its excess funds in higher yielding short-term investment securities during the first half of 2005.
Total interest expense for the second quarter of 2005 increased 73% to $6.2 million compared with $3.6 million for the same quarter in 2004. This increase was due to market rate increases and deposit growth.
Net interest income before provision for loan losses increased by $6.1 million for the second quarter of 2005 compared to the like quarter in 2004. Of this increase, approximately $2.6 million was due to volume changes $2.8 million was due to rate changes and $606,000 due to rate and rate/volume changes. The average yield on loans for the second quarter of 2005 increased to 7.53% compared to 5.74% for the like quarter in 2004, an increase of 179 basis points. This increase was mainly due to rate hikes in later part of 2004 through first half of 2005. The average investment portfolios for the second quarter of 2005 and 2004 were $171.9 million and $112.6 million, respectively. The average yields on the investment portfolio as of the second quarter of 2005 and 2004 were 3.49% and 3.16%, respectively.
The interest margin for the second quarter of 2005 equaled 4.92%, a 119 basis point increase compared to 3.73% for the same quarter of 2004. This increase in the net interest margin was mainly attributable to a 200 basis point increase in the prime and market rates set by the Federal Reserve Board since July 2004. The yield on earning assets for the second quarter of 2005 was 6.87%, 173 basis points higher than 5.14% in the same quarter of last year. This increase in 2005 was mainly due to the increase in loan yield as a result of market rate increases. Similarly, the average cost of interest-bearing liabilities increased to 2.76% in the second quarter of 2005 compared to 2.00% during the same quarter in 2004. This increase was driven by 107 basis points increase in average rate of time certificate of deposits.
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The following table presents the net interest spread, net interest margin, average balances, interest income and expense, and average yields and rates by asset and liability component for the three months ended June 30, 2005 and 2004:
Distribution, Rate and Yield Analysis of Net Income
Three Months Ended June 30, | ||||||||||||||||||
2005 | 2004 | |||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||
Average Balance | Interest Income/ Expense | Annualized Average Rate/Yield1 | Average Balance | Interest Income/ Expense | Annualized Rate/Yield1 | |||||||||||||
Assets: | ||||||||||||||||||
Interest-earning assets: | ||||||||||||||||||
Loans2 | $ | 1,068,492 | $ | 20,068 | 7.53 | % | $ | 843,084 | $ | 12,029 | 5.74 | % | ||||||
Federal funds sold | 25,263 | 188 | 2.98 | 39,294 | 102 | 1.04 | ||||||||||||
Taxable investment securities: | ||||||||||||||||||
U.S. Treasury | 1,267 | 14 | 4.43 | 2,111 | 24 | 4.57 | ||||||||||||
U.S. Governmental agencies debt securities | 78,978 | 618 | 3.14 | 40,332 | 280 | 2.79 | ||||||||||||
U.S. Governmental agencies mortgage backed securities | 66,948 | 614 | 3.68 | 36,274 | 297 | 3.29 | ||||||||||||
Municipal securities | 101 | 1 | 3.97 | 102 | 1 | 3.94 | ||||||||||||
Other securities3 | 14,657 | 175 | 4.79 | 16,835 | 152 | 3.63 | ||||||||||||
Total taxable investment securities: | 161,951 | 1,422 | 3.52 | 95,654 | 754 | 3.17 | ||||||||||||
Tax-advantaged investment securities4 | ||||||||||||||||||
Municipal securities | 5,098 | 53 | 6.42 | 5,469 | 56 | 6.34 | ||||||||||||
Others - Government preferred stock | 4,885 | 23 | 2.60 | 11,489 | 75 | 3.62 | ||||||||||||
Total tax-advantaged investment securities | 9,983 | 76 | 4.55 | 16,958 | 131 | 4.49 | ||||||||||||
Equity Stocks | 4,943 | 54 | 4.38 | 3,815 | 37 | 3.90 | ||||||||||||
Money market funds and interest-earning deposits | 3,564 | 27 | 3.04 | 28,352 | 71 | 1.01 | ||||||||||||
Total interest-earning assets | 1,274,196 | $ | 21,835 | 6.87 | % | 1,027,157 | $ | 13,124 | 5.14 | % | ||||||||
Non-interest earning assets: | ||||||||||||||||||
Cash and due from banks | 69,815 | 60,266 | ||||||||||||||||
Bank premises and equipment, net | 12,583 | 11,262 | ||||||||||||||||
Customers’ acceptances outstanding | 3,980 | 4,622 | ||||||||||||||||
Accrued interest receivables | 3,889 | 3,346 | ||||||||||||||||
Other assets | 27,830 | 24,824 | ||||||||||||||||
Total noninterest-earning assets | 118,097 | 104,320 | ||||||||||||||||
Total Assets | $ | 1,392,293 | $ | 1,131,477 | ||||||||||||||
1 | Average rates/yields for these periods have been annualized. |
2 | Loans are net of the allowance for loan losses, deferred fees, and discount on SBA loans retained. Loan fees (cost) included in loan income were approximately $290,000 and $11,000, for the three months ended June 30, 2005 and 2004, respectively. Amortized loan (cost) fees have been included in the calculation of net interest income. Nonaccrual loans have been included in the table for computation purposes, but the foregone interest of such loans is excluded. |
3 | Other securities include U.S. government asset-backed securities, corporate trust preferred securities, and corporate debt securities. |
4 | Yields on tax-advantaged income have been computed on a tax equivalent basis. 100% of earnings on municipal obligations and 70% of earnings on the preferred stock are not taxable for federal income tax purposes. |
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Distribution, Rate and Yield Analysis of Net Income
Three Months Ended June 30, | ||||||||||||||||||
2005 | 2004 | |||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||
Average Balance | Interest Income/ Expense | Annualized Rate/Yield5 | Average Balance | Interest Income/ Expense | Annualized Rate/Yield5 | |||||||||||||
Liabilities and Shareholders’ Equity: | ||||||||||||||||||
Interest-bearing liabilities: | ||||||||||||||||||
Deposits: | ||||||||||||||||||
Money market and NOW accounts | $ | 214,546 | $ | 975 | 1.82 | % | $ | 182,295 | $ | 677 | 1.49 | % | ||||||
Savings | 79,097 | 636 | 3.23 | 65,759 | 597 | 3.65 | ||||||||||||
Time certificates of deposit in: denominations of $100,000 or more | 476,913 | 3,546 | 2.98 | 368,506 | 1,686 | 1.84 | ||||||||||||
Other time certificates of deposit | 82,536 | 509 | 2.47 | 76,997 | 352 | 1.84 | ||||||||||||
853,092 | 5,666 | 2.66 | 693,557 | 3,312 | 1.92 | |||||||||||||
Other borrowed funds | 33,109 | 278 | 3.37 | 10,985 | 101 | 3.70 | ||||||||||||
Long-term subordinated debentures | 18,557 | 272 | 5.88 | 18,557 | 182 | 3.94 | ||||||||||||
Total interest-bearing liabilities | 904,758 | $ | 6,216 | 2.76 | % | 723,099 | $ | 3,595 | 2.00 | % | ||||||||
Non-interest-bearing liabilities: | ||||||||||||||||||
Demand deposits | 380,479 | 315,555 | ||||||||||||||||
Other liabilities | 8,154 | 10,709 | ||||||||||||||||
Total non-interest bearing liabilities | 388,633 | 326,264 | ||||||||||||||||
Shareholders’ equity | 98,902 | 82,114 | ||||||||||||||||
Total liabilities and shareholders’ equity | $ | 1,392,293 | $ | 1,131,477 | ||||||||||||||
Net interest income | $ | 15,619 | $ | 9,529 | ||||||||||||||
Net interest spread 6 | 4.11 | % | 3.14 | % | ||||||||||||||
Net interest margin7 | 4.92 | % | 3.73 | % | ||||||||||||||
Ratio of average interest-earning assets to interest-bearing liabilities | 140.83 | % | 142.05 | % | ||||||||||||||
Net interest income before provision for loan losses for the first half of 2005 was $29.6 million compared to $18.9 million for the first half of 2004, which constitutes an increase of $10.7 million, or 57%. Of this increase, approximately $5.8 million, $4.0 million, and $890,000 was due to volume, rate and rate/volume changes, respectively. Fueled by market rate increases, the average yield on loans for the first half of 2005 increased to 7.27% compared to 5.82% for the like period in 2004, an increase of 145 basis points. The average investment portfolios for the first half of 2005 and 2004 were $168.1 million and $117.8 million, respectively. The average yields on the investment portfolio as of the first half of 2005 and 2004 were 3.42% and 3.34%, respectively. Growth in higher cost time certificate of deposits had an unfavorable impact on the Company’s net interest margin. For the first half of 2005, time certificate of deposits grew $132.3 million or 32% as compared to the like period in 2004. Other borrowed funds for the first half of 2005, increased $9.7 million to $34.6 million compared to $24.8 million for the first half of 2004. This was due to increase in FHLB borrowings. The issuance of $18.0 million of long-term subordinated debenture in December 2003 contributed to the decline in the net interest margin, due to the higher cost of long-term subordinated debentures as compared to short-term borrowings such as fed funds purchased.
5 | Average rates/yields for these periods have been annualized. |
6 | Represents the weighted average yield on interest-earning assets less the weighted average cost of interest-bearing liabilities. |
7 | Represents net interest income (before provision for loan losses) as a percentage of average interest-earning assets. |
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The following table presents the net interest spread, net interest margin, average balances, interest income and expense, and average yields and rates by asset and liability component for the six months ended June 30, 2005 and 2004:
Distribution, Rate and Yield Analysis of Net Income
Six Months Ended June 30, | ||||||||||||||||||
2005 | 2004 | |||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||
Average Balance | Interest Income/ Expense | Annualized Average Rate/Yield8 | Average Balance | Interest Income/ Expense | Annualized Rate/Yield1 | |||||||||||||
Assets: | ||||||||||||||||||
Interest-earning assets: | ||||||||||||||||||
Loans 9 | $ | 1,048,268 | $ | 37,813 | 7.27 | % | $ | 808,987 | $ | 23,404 | 5.82 | % | ||||||
Federal funds sold | 26,318 | 359 | 2.75 | 31,951 | 163 | 1.03 | ||||||||||||
Taxable investment securities: | ||||||||||||||||||
U.S. Treasury | 1,644 | 38 | 4.66 | 2,126 | 49 | 4.63 | ||||||||||||
U.S. Governmental agencies debt securities | 71,084 | 1,053 | 2.99 | 42,844 | 614 | 2.88 | ||||||||||||
U.S. Governmental agencies mortgage backed securities | 67,856 | 1,250 | 3.71 | 38,501 | 680 | 3.55 | ||||||||||||
Municipal securities | 101 | 3 | 5.99 | 102 | 3 | 5.91 | ||||||||||||
Other securities10 | 15,479 | 359 | 4.68 | 16,856 | 306 | 3.65 | ||||||||||||
Total taxable investment securities: | 156,164 | 2,703 | 3.49 | 100,429 | 1,652 | 3.31 | ||||||||||||
Tax-advantaged investment securities11 | ||||||||||||||||||
Municipal securities | 5,098 | 106 | 6.45 | 5,650 | 116 | 6.35 | ||||||||||||
Others - Government preferred stock | 6,789 | 41 | 1.68 | 11,769 | 187 | 4.40 | ||||||||||||
Total tax-advantaged investment securities | 11,887 | 147 | 3.72 | 17,419 | 303 | 5.03 | ||||||||||||
Equity Stocks | 4,427 | 87 | 3.96 | 3,196 | 62 | 3.90 | ||||||||||||
Money market funds and interest-earning deposits | 3,571 | 50 | 2.82 | 20,440 | 102 | 1.00 | ||||||||||||
Total interest-earning assets | 1,250,635 | $ | 41,159 | 6.64 | % | 982,422 | $ | 25,686 | 5.26 | % | ||||||||
Non-interest earning assets: | ||||||||||||||||||
Cash and due from banks | 68,623 | 63,185 | ||||||||||||||||
Bank premises and equipment, net | 12,238 | 11,239 | ||||||||||||||||
Customers’ acceptances outstanding | 5,238 | 4,241 | ||||||||||||||||
Accrued interest receivables | 4,809 | 3,243 | ||||||||||||||||
Other assets | 27,707 | 24,329 | ||||||||||||||||
Total noninterest-earning assets | 118,615 | 106,237 | ||||||||||||||||
Total Assets | $ | 1,369,250 | $ | 1,088,659 | ||||||||||||||
8 | Average rates/yields for these periods have been annualized. |
9 | Loans are net of the allowance for loan losses, deferred fees, and discount on SBA loans retained. Loan (cost) fees included in loan income were approximately $703,000 and $104,000, for the six months ended June 30, 2005 and 2004, respectively. Amortized loan (cost) fees have been included in the calculation of net interest income. Nonaccrual loans have been included in the table for computation purposes, but the foregone interest of such loans is excluded. |
10 | Other securities include U.S. government asset-backed securities, corporate trust preferred securities, and corporate debt securities. |
11 | Yields on tax-advantaged income have been computed on a tax equivalent basis. 100% of earnings on municipal obligations and 70% of earnings on the preferred stock are not taxable for federal income tax purposes. |
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Distribution, Rate and Yield Analysis of Net Income
Six Months Ended June 30, | ||||||||||||||||||
2005 | 2004 | |||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||
Average Balance | Interest Income/ Expense | Annualized Rate/Yield12 | Average Balance | Interest Income/ Expense | Annualized Rate/Yield5 | |||||||||||||
Liabilities and Shareholders’ Equity: | ||||||||||||||||||
Interest-bearing liabilities: | ||||||||||||||||||
Deposits: | ||||||||||||||||||
Money market and NOW accounts | $ | 208,713 | $ | 1,815 | 1.75 | % | $ | 171,652 | $ | 1,227 | 1.44 | % | ||||||
Savings | 77,183 | 1,236 | 3.23 | 63,804 | 1,059 | 3.34 | ||||||||||||
Time certificates of deposit in: denominations of $100,000 or more | 470,597 | 6,482 | 2.78 | 344,425 | 3,150 | 1.84 | ||||||||||||
other time certificates of deposit | 82,309 | 954 | 2.34 | 76,161 | 697 | 1.84 | ||||||||||||
838,802 | 10,487 | 2.52 | 656,042 | 6,133 | 1.88 | |||||||||||||
Other borrowed funds | 34,562 | 532 | 3.10 | 24,829 | 270 | 2.18 | ||||||||||||
Long-term subordinated debentures | 18,557 | 538 | 5.84 | 18,557 | 365 | 3.96 | ||||||||||||
Total interest-bearing liabilities | 891,921 | $ | 11,557 | 2.61 | % | 699,428 | $ | 6,768 | 1.95 | % | ||||||||
Non-interest-bearing liabilities: | ||||||||||||||||||
Demand deposits | 367,615 | 296,808 | ||||||||||||||||
Other liabilities | 13,257 | 11,292 | ||||||||||||||||
Total non-interest bearing liabilities | 380,872 | 308,100 | ||||||||||||||||
Shareholders’ equity | 96,457 | 81,131 | ||||||||||||||||
Total liabilities and shareholders’ equity | $ | 1,369,250 | $ | 1,088,659 | ||||||||||||||
Net interest income | $ | 29,602 | $ | 18,918 | ||||||||||||||
Net interest spread13 | 4.02 | % | 3.31 | % | ||||||||||||||
Net interest margin14 | 4.77 | % | 3.87 | % | ||||||||||||||
Ratio of average interest-earning assets to interest-bearing liabilities | 140.22 | % | 140.46 | % | ||||||||||||||
12 | Average rates/yields for these periods have been annualized. |
6 | Represents the weighted average yield on interest-earning assets less the weighted average cost of interest-bearing liabilities. |
7 | Represents net interest income (before provision for loan losses) as a percentage of average interest-earning assets. |
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The following table sets forth, for the periods indicated, the dollar amount of changes in interest earned and paid for interest-earning assets and interest-bearing liabilities and the amount of change attributable to (i) changes in average daily balances (volume), (ii) changes in interest rates (rate), and (iii) changes in both rate and volume (rate/volume):
Three Months Ended June 30, 2005 vs. 2004 Increase (Decrease) Due to change In | Six Months Ended June 30, 2005 vs. 2004 Increase (Decrease) Due to change In | |||||||||||||||||||||||||||||||
Volume | Rate | Rate / Volume | Total | Volume | Rate | Rate / Volume | Total | |||||||||||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||||||||||||||||
Earning Assets | ||||||||||||||||||||||||||||||||
Interest Income: | ||||||||||||||||||||||||||||||||
Loans15 | $ | 3,225 | $ | 3,773 | $ | 1,041 | $ | 8,039 | $ | 6,904 | $ | 5,842 | $ | 1,663 | $ | 14,409 | ||||||||||||||||
Federal funds sold | (37 | ) | 190 | (67 | ) | 86 | (29 | ) | 273 | (48 | ) | 196 | ||||||||||||||||||||
Taxable investment securities | 524 | 84 | 60 | 668 | 914 | 91 | 46 | 1,051 | ||||||||||||||||||||||||
Tax-advantaged securities16 | (54 | ) | (2 | ) | 1 | (55 | ) | (96 | ) | (87 | ) | 27 | (156 | ) | ||||||||||||||||||
Equity stocks | 11 | 5 | 1 | 17 | 24 | 1 | — | 25 | ||||||||||||||||||||||||
Money market funds and interest-earning deposits | (63 | ) | 144 | (125 | ) | (44 | ) | (84 | ) | 184 | (152 | ) | (52 | ) | ||||||||||||||||||
Total earning assets | 3,606 | 4,194 | 911 | 8,711 | 7,633 | 6,304 | 1,536 | 15,473 | ||||||||||||||||||||||||
Interest Expense: | ||||||||||||||||||||||||||||||||
Deposits and borrowed funds | ||||||||||||||||||||||||||||||||
Money market and super NOW accounts | 121 | 150 | 26 | 297 | 265 | 270 | 58 | 593 | ||||||||||||||||||||||||
Savings deposits | 121 | (69 | ) | (14 | ) | 38 | 221 | (34 | ) | (7 | ) | 180 | ||||||||||||||||||||
Time deposits | 523 | 1,186 | 310 | 2,019 | 1,207 | 1,821 | 553 | 3,581 | ||||||||||||||||||||||||
Other borrowings | 204 | (10 | ) | (17 | ) | 177 | 106 | 114 | 42 | 262 | ||||||||||||||||||||||
Long-term subordinated debentures | — | 90 | — | 90 | — | 173 | — | 173 | ||||||||||||||||||||||||
Total interest-bearing liabilities | 969 | 1,347 | 305 | 2,621 | 1,799 | 2,344 | 646 | 4,789 | ||||||||||||||||||||||||
Net interest income | $ | 2,637 | $ | 2,847 | $ | 606 | $ | 6,090 | $ | 5,834 | $ | 3,960 | $ | 890 | $ | 10,684 | ||||||||||||||||
Provision for Loan Losses
Credit risk is inherent in the business of making loans. The Company sets aside an allowance for potential loan losses through charges to earnings, which are reflected monthly in the income statement as the provision for loan losses. Specifically, the provision for loan losses represents the amount charged against current period earnings to achieve an allowance for loan losses that in Management’s judgment is adequate to absorb losses inherent in the Company’s loan portfolio.
Because of the loan portfolio growth, the provision for loan losses for the second quarter and first half of 2005, were $1.1 million and $1.7 million, respectively, as compared to $600,000 and $1.5 million, respectively, for the same periods in prior year. Management believes that the provision for loan losses provision was adequate for the first half of 2005. While Management believes that the allowance for loan losses of 1.1% of total loans at June 30, 2005 was adequate, future additions to the allowance will be subject to continuing evaluation of the estimation, inherent and other known risks in the loan portfolio. The procedures for monitoring the adequacy of the allowance, and detailed information on the allowance, are included below in “Allowance for Loan Losses.”
Noninterest Income
Noninterest income includes revenues earned from sources other than interest income. The primary sources of noninterest income include customer service charges and fees on deposit accounts, fees and commissions generated from trade finance activities and issuance of letters of credit, ancillary fees on loans, net gains on sales of loans and net gains on sale of investment securities available for sale.
15 | Loans are net of the allowance for loan losses, deferred fees, and discount on SBA loans retained. Loan fees included in loan income were approximately $703,000 and $104,000, for the six months ended June 30, 2005 and 2004, respectively. Amortized loan fees have been included in the calculation of net interest income. Nonaccrual loans have been included in the table for computation purposes, but the foregone interest of such loans is excluded. |
16 | Yield on tax-advantaged income have been computed on a tax equivalent basis. 100% of earnings on municipal obligations and 70% of earnings on the preferred stock are not taxable for federal income tax purposes. |
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For the second quarter of 2005, noninterest income grew 3% to $5.0 million compared to $4.9 million for the same quarter in 2004, but decreased from 1.91% to 1.58% of average earning assets for the same periods. Noninterest income was up by 12% to $10.1 million for the first half of 2005 as compared to $9.0 million in the comparable period of 2004.
The primary sources of recurring noninterest income continue to be customer service fee charges on deposit accounts and fees from trade finance transactions. Customer service fees increased by $434,000, or 22%, in the second quarter of 2005, and by $753,000, or 19% for the first six months of 2005, compared to the same period last year. The increase in customer service fees was mainly due to increases in customer account relationships as a result of geographical expansion. For the first half of 2005, customer service fees as a percentage of total core noninterest income increased to 46% compared to 44% for the first half of 2004.
Fee income from trade finance transactions increased by $14,000, or 2%, for the second quarter, and $213,000, or 13% for the first six months of 2005. This increase in trade finance loans was mainly due to Management’s efforts to capitalize on improving trends in the Asia Pacific trade volumes and a new trade finance team brought in during 2003.
The Company recorded a gain of $592,000 on the sale of loans in the second quarter of 2005, as compared to the $890,000 like quarter of 2004. However, the gain on sale of loans remained flat at $1.3 million for the first half 2005 and 2004. The Company sold $26.5 million of guaranteed and unguaranteed portion of SBA loans during the first half of 2005 as compared to $19.1 million of guaranteed portion of SBA loans in comparable period of 2004.
Loan service fees was slightly lower by $39,000 and $150,000 for the quarter and first half of 2005 as compared to prior year, mainly due to the decrease in loan documentation fee income and increase in servicing asset amortization. Loan service fees amounted to $419,000 and $859,000, respectively, for the first half and second quarter of 2005 as compared to $458,000 and $1.0 million, respectively, for same periods last year.
Other income decreased by 8% to $394,000 for the second quarter of 2005, as compared to $426,000 in the like period of 2004. The decrease was mainly due to a decrease in other charges and fees. Other income for the six months ended June 30, 2005 increased to $927,000 in comparison to $779,000 for the same period in 2004. The increase is attributable to a settlement received in the first quarter and fee income generated from outsourcing official check processing.
The following table sets forth the various components of the Company’s noninterest income for the periods indicated:
Noninterest Income
For the Three Months Ended June 30, | For the Six Months Ended June 30, | |||||||||||||||||||||||||||
2005 | 2004 | 2005 | 2004 | |||||||||||||||||||||||||
Amount | Percent of Total | Amount | Percent of Total | Amount | Percent of Total | Amount | Percent of Total | |||||||||||||||||||||
(Dollars in thousands) | ||||||||||||||||||||||||||||
Noninterest income: | ||||||||||||||||||||||||||||
Customer service fee | $ | 2,428 | 48.42 | % | $ | 1,994 | 40.78 | % | $ | 4,663 | 46.39 | % | $ | 3,910 | 43.57 | % | ||||||||||||
Fee income from trade finance transactions | 929 | 18.53 | 915 | 18.71 | 1,831 | 18.22 | 1,618 | 18.03 | ||||||||||||||||||||
Wire transfer fees | 251 | 5.01 | 213 | 4.36 | 455 | 4.53 | 398 | 4.43 | ||||||||||||||||||||
Gain on sale of loans | 592 | 11.81 | 890 | 18.20 | 1,265 | 12.59 | 1,267 | 14.12 | ||||||||||||||||||||
Net gain on sale of securities available for sale | 1 | 0.02 | (6 | ) | (0.12 | ) | 51 | 0.51 | (6 | ) | (0.07 | ) | ||||||||||||||||
Other loan related service fees | 419 | 8.36 | 458 | 9.37 | 859 | 8.55 | 1,009 | 11.24 | ||||||||||||||||||||
Other income | 394 | 7.85 | 426 | 8.70 | 927 | 9.21 | 779 | 8.68 | ||||||||||||||||||||
Total noninterest income: | $ | 5,014 | 100.00 | % | $ | 4,890 | 100.00 | % | $ | 10,051 | 100.00 | % | $ | 8,975 | 100.00 | % | ||||||||||||
As a percentage of average earning assets: | 1.58 | % | 1.91 | % | 1.62 | % | 1.85 | % |
Noninterest Expense
For the second quarter of 2005, mainly due to mark to market losses on the Company’s interest rate swaps for the second quarter 2004, noninterest expense decreased by $1.1 million to $9.5 million compared to $10.6 million in same period last year. Noninterest expense, as a percentage of average assets, decreased to 2.98% in the second quarter of 2005 as compared to 4.14% in same period in 2004. Noninterest expense for the first half of 2005 increased 10% to $19.0 million compared with $17.2 million for the first half of 2004.
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Throughout the remainder, comparisons of noninterest expense will be made excluding the mark to market adjustments related to the swaps to facilitate the discussion of comparisons and fluctuations.
Noninterest expense for the second quarter of 2005 decreased 10% to $9.5 million, compared to $10.6 million for the same quarter in 2004. This decrease in noninterest expense was mainly attributable to decrease in mark to market losses on the Company’s interest rate swaps of $2.0 million offset by increases in salaries and benefits and occupancy cost related to the Company’s continuing growth and geographical expansion. However, noninterest expense as a percentage of average assets decreased to 2.98% in the second quarter of 2005 as compared to 4.14% in same period in 2004. Noninterest expense for the first half of 2005 increased 10% to $19.0 million compared with $17.2 million for the first half of 2004.
The Company’s efficiency ratio, is defined as the ratio of noninterest expense to the sum of net interest income before provision for loan losses and noninterest income. As a reflection of increased noninterest expenses, efficiency ratio decreased substantially to 46% and 48%, respectively, for the second quarter and year ended June 30, 2005, compared to 73% and 62% in the like period a year ago. These improvements were primarily the result of increased interest income as a result of market rate increases and increased contributions from new branches, and the implementation of expense controls
Compensation and employee benefits increased 23% and 22% to $4.5 million and $9.0 million, for the second quarter and six months ended June 30, 2005, respectively, compared to $3.7 million and $7.4 million, respectively, for the same periods in 2004. Compensation and employee benefits as a percentage of average earning assets also increased from 43% to 47% for the second quarter of 2005 as compared to same period last year, excluding these mark to market adjustments related to Company’s interest rate swaps prior to the second quarter 2005. This increase in the dollar volume was mainly due to expenses associated with the increased personnel to staff the new branches, the increased hiring activity of highly qualified personnel, and normal salary increases.
Our continuing geographical expansion increased occupancy cost by 27% to $854,000 in the second quarter of 2005 from $672,000 in same quarter last year. Occupancy expense also increased to $1.6 million for the first half of 2005 as compared to $1.2 million in like period last year.
Our expansion to other geographical areas was a major contributor to the increase in furniture, fixture, and equipment expense which totaled $407,000 and $815,000, respectively, for the three months and six months ended June 30, 2005, an increase of 24% and 25%, respectively, as compared to $329,000 and $650,000, respectively, in same period of 2004.
Professional service fees decreased slightly by $53,000 to $1.1 million for second quarter 2005 compared to $1.2 million in same period of 2004. However, professional service fees were higher for the first half of 2005 and amounted to $1.9 million, or an increase of $601,000 as compared to $1.3 million for the same period last year. The increase was primarily attributable to costs related to Sarbanes-Oxley Act compliance, in particular, cost associated with the new requirement of an audit of the Company’s internal controls, as well as additional costs associated with ongoing litigation. Professional service fees as a percentage of total noninterest expense also increased in the first half of 2005 to 10% from 8% same period of 2004.
Business promotion and advertising expense increased by 10% and 42%, respectively, for the second quarter and six months ended June 30, 2005, to $666,000 and $1.3 million, respectively, as compared to $604,000 and $925,000, respectively, in like periods a year ago. This increase was mainly due to the increased promotional activity for the Company’s products and new Loan Production Offices.
During the first half of 2005, the Company did not record any losses related to impairment losses of securities available for sale as compared to the recorded loss of $540,000 during the first half of 2004. The impairment losses were recorded due to an other than temporary decline in market value due to the changes in interest rates on Fannie Mae and Freddie Mac preferred stock. The Company sold a portion of its U.S. Government sponsored enterprise preferred stock, which had been the subject of the 2004 impairment loss during the first quarter of 2005. The Company currently holds approximately $5.0 million of Fannie Mae floating-rate securities that reset ever two years at the 2-year U.S. Treasury Note minus 16bps. The next reset date is on March 20, 2006. Should there be additional permanent impairments on these securities in the future, these impairments would be recognized on the income statement. However, it is impossible to predict at this time whether or to what extent such losses will occur.
During the first half of 2005, the Company terminated one of its longer maturity interest rate swaps and recorded a net loss of $306,000. There was no loss recorded for the same period last year other than losses relating to mark to market adjustments in the swaps.
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During the first six months of 2005, the Company used hedge accounting on its interest rate swaps for the second quarter. The swaps did not qualify for this treatment during the first quarter of 2005, or in 2004. When hedge accounting is not used the impact of changes in the market value of the hedge instruments is recognized in current earnings. During the first quarter of 2005 (and consequently for the first six months of 2005) a gain of $77,000 was recognized compared to a loss of $1,452,000 in the first six months of 2004. These amounts are included in noninterest Expense in both periods.
Other operating expenses decreased by $157,000 for the second quarter of 2005, and $52,000 for the first half of 2005. This decrease was mainly due to decrease in administration expenses and loss from disposal of fixed assets.
The remaining noninterest expenses include such items as data processing, stationery and supplies, telecommunications, postage, courier service and security service expenses. For the second quarter of 2005, these noninterest expenses increased to $1.3 million compared to $1.1 million for the same quarter in 2004. This increase was mainly attributable to expenses related to the new Valley branch and new LPOs. The remaining noninterest expenses also was higher for the first half of 2005 and amounted to $2.4 for the six months ended June 30, 2005 as compared to $2.1 million for like period last year.
The following table sets forth the breakdown of noninterest expense for the periods indicated:
Noninterest Expense
For the Three Months Ended June 30, | For the Six Months Ended June 30, | ||||||||||||||||||||||||
2005 (Unaudited) | 2004 (Unaudited | 2005 (Unaudited) | 2004 (Unaudited | ||||||||||||||||||||||
Amount | Percent of Total | Amount | Percent of Total | Amount | Percent of Total | Amount | Percent of Total | ||||||||||||||||||
(Dollars in thousands) | |||||||||||||||||||||||||
Salaries and benefits | $ | 4,532 | 47.85 | % | $ | 3,675 | 34.79 | % | $ | 8,977 | 47.26 | % | $ | 7,357 | 42.69 | % | |||||||||
Occupancy | 854 | 9.02 | 672 | 6.36 | 1,569 | 8.26 | 1,209 | 7.01 | |||||||||||||||||
Furniture, fixture, and equipment | 407 | 4.30 | 329 | 3.11 | 815 | 4.29 | 650 | 3.77 | |||||||||||||||||
Data processing | 477 | 5.04 | 506 | 4.79 | 942 | 4.96 | 974 | 5.65 | |||||||||||||||||
Professional services fees | 1,108 | 11.70 | 1,161 | 10.99 | 1,906 | 10.03 | 1,305 | 7.57 | |||||||||||||||||
Business promotion and advertising | 666 | 7.03 | 604 | 5.72 | 1,316 | 6.93 | 925 | 5.37 | |||||||||||||||||
Stationery and supplies | 236 | 2.49 | 127 | 1.20 | 413 | 2.17 | 233 | 1.35 | |||||||||||||||||
Telecommunications | 170 | 1.79 | 157 | 1.49 | 299 | 1.57 | 283 | 1.64 | |||||||||||||||||
Postage and courier service | 187 | 1.97 | 158 | 1.50 | 350 | 1.84 | 287 | 1.67 | |||||||||||||||||
Security service | 197 | 2.08 | 167 | 1.58 | 372 | 1.96 | 322 | 1.87 | |||||||||||||||||
Impairment loss of available for sale securities | — | — | — | — | — | — | 540 | 3.13 | |||||||||||||||||
Loss on termination of interest rate swaps | — | — | — | — | 306 | 1.62 | — | — | |||||||||||||||||
(Gain)loss on interest rate swaps: | |||||||||||||||||||||||||
Swap Mark to Market | (231 | ) | (2.44 | ) | 1,986 | 18.80 | 77 | 0.41 | 1,452 | 8.43 | |||||||||||||||
Swap Ineffectiveness | 6 | 0.06 | — | — | 6 | 0.03 | — | — | |||||||||||||||||
Other operating expense | 863 | 9.11 | 1,021 | 9.67 | 1,646 | 8.67 | 1,698 | 9.85 | |||||||||||||||||
Total noninterest expense | $ | 9,472 | 100.00 | % | $ | 10,563 | 100.00 | % | $ | 18,994 | 100.00 | % | $ | 17,235 | 100.00 | % | |||||||||
As a percentage of average earning assets | 2.98 | % | 4.14 | % | 3.06 | % | 3.55 | % | |||||||||||||||||
Efficiency ratio | 45.91 | % | 73.26 | % | 47.90 | 61.79 | % |
* | (See “Restatement” portion of Note 2) |
Provision for Income Taxes
Income tax expense is the sum of two components, current tax expense and deferred tax expense. Current tax expense is the result of applying the current tax rate to taxable income. The deferred portion is intended to reflect that income on which taxes are paid versus financial statement pre-tax income, because some items of income and expense are recognized in different years for income tax purposes than for the financial statement purposes.
The provision for income taxes amounted to $4.0 million for the second quarter of 2005 compared to $1.2 million for the same period in 2004, and the effective tax rates were 39.34% and 37.10%, respectively, for the second quarter of 2005 and 2004. The increase in the tax provision was attributable to a 211% increase in pretax earnings in the second quarter of 2005 compared to the same period a year ago. The Company reduced taxes utilizing the tax credits from investments in the low-income housing projects in the amount of $147,000 for the first half of 2005 compared to $259,000 for the six months ended in June 30, 2004.
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Deferred income tax assets or liabilities reflect the estimated future tax effects attributable to differences as to when certain items of income or expense are reported in the financial statements versus when they are reported in the tax return. The Company’s deferred tax asset was $6.3 million as of June 30, 2005, and $7.1 million as of December 31, 2004. As of June 30, 2005, the Company’s deferred tax asset was primarily due to the allowance for losses on loans. Deferred tax assets were partially offset by unrecognized gains from securities that are available for sale.
The major components of the Company’s earning asset base are its interest-earning short-term investments, investment securities portfolio and loan portfolio. The detailed composition and growth characteristics of these three portfolios are significant to any analysis of the financial condition of the Company, and the loan portfolio analysis will be discussed in a later section of this Form 10-Q.
Interest Earning Short-Term Investments
The Company invests its excess available funds from daily operations in overnight Fed Funds and Money Market Funds. Money Market Funds are composed mostly of government funds and high quality short-term commercial paper. The Company can redeem the funds at any time. As of June 30, 2005 and December 31, 2004, the amounts invested in Fed Funds were $50.2 million and $35.9 million, respectively. The average yield earned on these funds was 2.75% for the first six months of 2005 compared to 1.03% for the same period last year. The Company invested $3.6 million and $3.7 million in money market funds and interest bearing deposits in other banks as of June 30, 2005 and December 31, 2004. The average balance and yield on money market funds and interest bearing deposits in other banks were $3.6 million and 2.82% for the first half of 2005 as compared to $20.4 million and 1.00% for the comparable period of 2004.
Investment Portfolio
As of June 30, 2005, investment securities totaled $199.4 million or 13% of total assets, compared to $168.4 million or 13% of total assets as of December 31, 2004. The increase of $31.0 million in the investment portfolio was due to: $96.7 million of purchases of U.S. government agency and U.S. government sponsored enterprise securities and U.S. government sponsored enterprise mortgage-backed securities. These purchases were partially offset by: (i) $42.5 million in available-for-sale U.S. Treasury, U.S. government sponsored enterprise securities and corporate bonds, which matured during the first half, (ii) $7.5 million in available-for-sale U.S. government sponsored enterprise preferred stocks and $1.0 million corporate bonds sold during the period, (iii) 5.0 million of $ U.S. government agency and U.S. government sponsored enterprise securities called, and (iv) a principal payment of $6.8 million made on mortgage-backed securities.
As of June 30, 2005, available-for-sale securities totaled $189.1 million, compared to $157.0 million as of December 31, 2004. Available-for-sale securities as a percentage of total assets slightly increased to 13% at June 30, 2005, as compared to 13% as of December 31, 2004. Held-to-maturity securities decreased to $10.2 million as of June 30, 2005, compared to $11.4 million as of December 31, 2004. This decrease was due to the principal payments on mortgage backed securities. The composition of available-for-sale and held-to-maturity securities was 95% and 5% as of June 30, 2005, compared to 93% and 7% as of December 31, 2004, respectively. For the three months and six months ended June 30, 2005, the yield on the average investment portfolio was 3.49% 3.42%, respectively, as compared to 3.16% and 3.34% respectively, for the same periods of 2004. This increase was mainly due to market rate hikes and replacing matured and call securities with higher yielding new securities This increase partially offset by selling $6.5 million of the Freddie Mac preferred stocks and reversing the accrued dividends associated with these securities. The Company purchased additional mortgage-backed securities and U.S government agency and U.S. Government sponsored enterprise securities during the first half of 2005. The Company used cash flows generated from prepayments in mortgage-backed securities to purchase U.S. government agency and U.S. Government sponsored enterprise securities and adjustable mortgage-backed securities. Part of the proceeds was also used to fund higher yielding loans.
As a result of additional purchases, the average balance of taxable investment securities increased by 56% to $156.2 million for the six months ended June 30, 2005, compared to $100.4 million for the same period of previous year. The annualized average yield increased 18 basis points to 3.49% for the six months ended June 30, 2005, compared to 3.31% for the previous year.
The average balance of tax-advantaged securities was $11.9 million and $17.4 million for the six months ended June 30, 2005 and 2004, respectively. The average yield on tax-advantaged securities for the year ended June 30, 2005 was 2.49% compared to 3.50% for the same period last year. This decrease was mainly due to decrease yield on U.S. Government sponsored enterprise preferred stock. The tax-equivalent yield on these same types of securities for the six months ended June 30, 2005 was 3.72%
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compared to 5.03% for the same period last year. The decrease in yield on the tax advantage securities was primarily due to lower yielding U.S. Government sponsored enterprise preferred stock.
The following table summarizes the amortized cost, fair value and distribution of the Company’s investment securities as of the dates indicated:
Investment Portfolio
As of June 30, | As of December 31 | |||||||||||
2005 | 2004 | |||||||||||
Amortized Cost | Fair Value | Amortized Cost | Fair Value | |||||||||
(Dollars in thousands) | ||||||||||||
Available for Sale: | ||||||||||||
U.S. Treasury securities | $ | 498 | $ | 498 | $ | 2,014 | $ | 2,033 | ||||
U.S. Government agencies asset-backed securities | 1 | 1 | 6 | 6 | ||||||||
U.S. Government agencies and U.S. Government sponsored enterprise securities | 105,472 | 104,501 | 66,535 | 65,747 | ||||||||
U.S. Government agencies and U.S. Government sponsored enterprise mortgage-backed securities | 65,272 | 64,996 | 62,294 | 62,279 | ||||||||
U.S. Government sponsored enterprise preferred stock | 4,865 | 4,923 | 10,092 | 10,138 | ||||||||
Corporate trust preferred securities | 11,000 | 11,033 | 11,000 | 11,028 | ||||||||
Corporate debt securities | 3,192 | 3,197 | 5,698 | 5,796 | ||||||||
Total available for sale | $ | 190,300 | $ | 189,149 | $ | 157,639 | $ | 157,027 | ||||
Held to Maturity: | ||||||||||||
U.S. Government agencies and U.S. Government sponsored enterprise mortgage-backed securities | 5,048 | 4,997 | 6,197 | 6,161 | ||||||||
Municipal securities | 5,198 | 5,325 | 5,199 | 5,392 | ||||||||
Total held to maturity | $ | 10,246 | $ | 10,322 | $ | 11,396 | $ | 11,553 | ||||
Total investment securities | $ | 200,546 | $ | 199,471 | $ | 169,035 | $ | 168,580 | ||||
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The following table summarizes, as of June 30, 2005, the maturity characteristics of the investment portfolio, by investment category. Expected remaining maturities may differ from remaining contractual maturities because obligors may have the right to prepay certain obligations with or without penalties.
Investment Maturities and Repricing Schedule
(Dollars in thousands) | ||||||||||||||||||||||||||||||
Within One Year | After One But Within Five Years | After Five But Within Ten Years | After Ten Years | Total | ||||||||||||||||||||||||||
Amount | Yield17 | Amount | Yield11 | Amount | Yield | Amount | Yield17 | Amount | Yield17 | |||||||||||||||||||||
Available for Sale (Fair Value): | ||||||||||||||||||||||||||||||
U.S. Treasury securities | $ | 498 | 2.76 | % | $ | — | — | $ | — | — | $ | — | — | $ | 498 | 2.76 | % | |||||||||||||
U.S. Government agencies asset- backed securities | 1 | 2.71 | — | — | — | — | — | — | 1 | 2.71 | ||||||||||||||||||||
U.S. Government agencies and U.S. Government sponsored enterprise securities | 29,904 | 1.09 | 74,598 | 3.00 | — | — | — | — | 104,501 | 2.45 | ||||||||||||||||||||
U.S. Government agencies and U.S. Government sponsored enterprise mortgage-backed securities | — | — | 2,752 | 4.7 | 3,815 | 4.48 | 58,429 | 3.71 | 64,996 | 3.80 | ||||||||||||||||||||
U.S. Government sponsored enterprise preferred stock | 4,923 | 1.16 | — | — | — | — | — | — | 4,923 | 1.16 | ||||||||||||||||||||
Corporate trust preferred securities | — | — | — | — | — | — | 11,033 | 4.92 | 11,033 | 4.92 | ||||||||||||||||||||
Corporate debt securities | 1,014 | 5.80 | 2,183 | 3.96 | — | — | — | — | 3,197 | 4.78 | ||||||||||||||||||||
Total available for sale securities | $ | 36,340 | 1.25 | $ | 79,533 | 3.08 | $ | 3,815 | 4.48 | $ | 69,462 | 3.91 | $ | 189,149 | 3.04 | |||||||||||||||
Held to Maturity (Amortized Cost): | ||||||||||||||||||||||||||||||
U.S. Government agencies and U.S. Government sponsored enterprise mortgage-backed securities | — | — | — | — | — | — | 5,048 | 3.88 | 5,048 | 3.88 | ||||||||||||||||||||
Municipal securities | — | — | 2,108 | 4.27 | 3,090 | 4.12 | — | — | 5,198 | 4.18 | ||||||||||||||||||||
Total held to maturity | $ | — | — | $ | 2,108 | 4.27 | $ | 3,090 | 4.12 | $ | 5,048 | 3.88 | $ | 10,246 | 4.03 | |||||||||||||||
Total investment securities | $ | 36,340 | 1.25 | % | $ | 81,641 | 3.11 | % | $ | 6,905 | 4.32 | % | $ | 74,509 | 3.90 | % | $ | 199,395 | 3.09 | % | ||||||||||
The following table shows the Company’s investments with gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at June 30, 2005:
Less than 12 months | 12 months or more | Total | |||||||||||||||||||
Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | Fair Value | Unrealized Loss | ||||||||||||||||
(Dollars in thousands) | |||||||||||||||||||||
U.S. Government and U.S. Government sponsored enterprise agencies securities | $ | 71,312 | $ | (173 | ) | $ | 27,188 | $ | (798 | ) | $ | 98,500 | $ | (971 | ) | ||||||
U.S. Government agencies and U.S. Government sponsored enterprise mortgage-backed securities | 42,719 | (393 | ) | 3,212 | (20 | ) | 45,931 | (413 | ) | ||||||||||||
Corporate debt securities | 1,180 | (13 | ) | — | — | 1,180 | (13 | ) | |||||||||||||
Total | $ | 115,211 | $ | (579 | ) | $ | 30,400 | $ | (818 | ) | $ | 145,611 | $ | (1,397 | ) | ||||||
As of June 30, 2005, the Company has total fair value of $145.6 million of securities with unrealized losses of $1.4 million. We believe these unrealized losses are due to a temporary condition, namely fluctuations in interest rates, and do not reflect a deterioration of credit quality of the issuer. The market value of securities which have been in a continuous loss position for 12 months or more totaled to $30.4 million with unrealized losses of $818,000. The Company sold $6.5 million of the Freddie Mac preferred stocks during the first quarter of 2005.
17 | Yields on tax-advantaged income have been computed on a tax equivalent basis. 100% of earnings on municipal obligations and 70% of earnings on the preferred stock are not taxable for federal income tax purposes. |
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All individual securities that have been in a continuous unrealized loss position for twelve months or longer at June 30, 2005 had investment grade ratings upon purchase. The issuers of these securities have not, to our knowledge, established any cause for default on these securities and the various rating agencies have reaffirmed these securities’ long term investment grade status at June 30, 2005. These securities have fluctuated in value since their purchase dates as market interest rates have fluctuated. However, the Company has the ability, and management intends, to hold these securities until their fair values recover to cost.
Loan Portfolio
The Company’s moderate loan growth continued during the first half of 2005. Net loans increased $99.8 million, or 10%, to $1.1 billion at June 30, 2005, as compared to $1.0 billion at December 31, 2004. The increase in loans was funded primarily through deposit growth coming from established branches. While Management believes that it can continue to leverage the Company’s current infrastructure to achieve similar or greater growth in loans for the remainder of the year, no assurance can be given that such growth will in fact occur. Net loans as of June 30, 2005, represented 74% of total assets, compared to 76% as of December 31, 2004.
The growth in net loans is comprised primarily of net increases in real estate commercial loans of $73.9 million or 12%, commercial business loans of $28.3 million, or 14%, consumer loans of $5.6 million or 10%, SBA loans of $3.9 million or 8%. Partially offsetting the growth in these loan categories was a net decrease in construction loans of $5.7 million or 34% and trade finance loans of $4.2 million or 5%.
As of June 30, 2005, commercial real estate remained the largest component of the Company’s total loan portfolio with loans totaling $681.2 million, representing 60% of total loans, compared to $607.3 million or 59% of total loans at December 31, 2004. The increase in commercial real estate loans resulted from Management’s continued efforts to promote this portion of the loan portfolio, which entails a somewhat lesser degree of risk than certain other loans in the portfolio due to the nature and value of the collateral.
Commercial business loans increased by $28.3 million during the first six months ended June 30, 2005 to $237.3 million as compared $209.0 million at year end 2004, mainly due to increased activity in other commercial business loans.
Trade finance loans decreased by $4.2 million or 5% to $79.6 million at June 30, 2005 from $83.8 million at December 31, 2004. This decrease in trade finance loans was mainly due to decreased activity in documentary negotiable advances.
The Company sold $26.5 million of guaranteed and unguaranteed portions of SBA loans in the first half of 2005, and retained the obligation to service the loans for a servicing fee and to maintain customer relations. As of June 30, 2005, the Company was servicing $148.4 million of sold SBA loans, compared to $137.5 million of sold SBA loans as of December 31, 2004. Despite continuing sales of SBA loans, SBA loans increased to $52.9 million at June 30, 2005, which is an increase of $3.9 million, or 7.9%, compared to last year-end.
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The following table sets forth the composition of the Company’s loan portfolio as of the dates indicated:
June 30, 2005 | December 31, 2004 | |||||||||||||
Amount | Percent of Total | Amount | Percent of Total | |||||||||||
(Dollars in thousands) | ||||||||||||||
Real Estate | ||||||||||||||
Construction | $ | 11,172 | 0.99 | % | $ | 16,919 | 1.65 | % | ||||||
Commercial 18 | 681,200 | 60.48 | 607,296 | 59.25 | ||||||||||
Commercial | ||||||||||||||
Korean Affiliate Loans 19 | 15,791 | 1.40 | 15,979 | 1.56 | ||||||||||
Other commercial loans | 221,496 | 19.67 | 193,016 | 18.83 | ||||||||||
Trade Finance 20 | ||||||||||||||
Korean Affiliate Loans | 2,000 | 0.18 | 2,734 | 0.27 | ||||||||||
Other trade finance loans | 77,565 | 6.89 | 81,029 | 7.90 | ||||||||||
SBA | 33,918 | 3.01 | 34,504 | 3.37 | ||||||||||
SBA held for sale 21 | 18,992 | 1.69 | 14,523 | 1.41 | ||||||||||
Other22 | 296 | 0.03 | 864 | 0.08 | ||||||||||
Consumer | 63,733 | 5.66 | 58,178 | 5.68 | ||||||||||
Total Gross Loans | 1,126,163 | 100.00 | % | 1,025,042 | 100.00 | % | ||||||||
Less: | ||||||||||||||
Allowance for Loan Losses | (12,538 | ) | (11,227 | ) | ||||||||||
Deferred Loan Fees | (1,370 | ) | (1,356 | ) | ||||||||||
Discount on SBA Loans Retained | (2,003 | ) | (1,986 | ) | ||||||||||
Total Net Loans | $ | 1,110,252 | $ | 1,010,473 | ||||||||||
The Company has historically made four types of credit extensions involving direct exposure to the Korean economy: (i) commercial loans to U.S. affiliates or subsidiaries or branches of companies located in South Korea (“Korean Affiliate Loans”), (ii) unused commitments for loans to U.S. affiliates of Korean companies (iii) advances on acceptances by Korean banks, and (iv) loans against standby letters of credit issued by Korean banks. In certain instances, standby letters of credit issued by Korean banks support the loans made to the U.S. affiliates or branches of Korean companies, to which the Company has extended loans. In addition, the Company makes certain loans involving indirect exposure to the economies of South Korea as well as other Pacific Rim countries, as discussed at the end of this section.
The following table sets forth the amounts of outstanding balances in the above four categories for South Korea:
Loans and Commitments Involving Korean Country Risk
June 30, 2005 | December 31, 2004 | |||||
(Dollars in thousands) | ||||||
Category | ||||||
Commercial loans and commitments to U.S. affiliates or branches of Korean companies | $ | 11,733 | $ | 12,772 | ||
Unused commitments for loans to U.S. affiliates of Korean Companies | 20,384 | 15,169 | ||||
Acceptances with Korean Banks | 12,427 | 14,623 | ||||
Standby letters of credit issued by banks in South Korea and loans secured by standby letter of credit | 9,638 | 10,527 | ||||
Total | $ | 54,182 | $ | 53,091 | ||
Loans and commitments involving direct exposure to the Korean economy totaled $54.2 million or 4% of total loans and commitments and $53.1 million or 4% of total loans and commitments as of June 30, 2005 and December 31, 2004, respectively.
18 | Real estate commercial loans are loans secured by first deeds of trust on real estate |
19 | Consists of loans to U.S. affiliates or subsidiaries or branches of Korean companies. |
20 | Includes advances on trust receipts, clean advances, cash advances, acceptances discounted, and documentary negotiable advances under commitments. |
21 | SBA loans held for sale is stated at the lower of cost or market. |
22 | Consists of transactions in process and overdrafts. |
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The Company’s level of loans and commitments involving such exposure on June 30, 2005 has increased as compared to December 31, 2004, primarily due to a $5.2 million increase in unused commitments for loans to U.S. affiliates of Korean Companies.
In addition to the loans included in the above table, which involve direct exposure to the Korean economy, the Company also makes loans to many U.S. business customers in the import or export business whose operations are indirectly affected by the economies of various Pacific Rim countries including South Korea. As of June 30, 2005, loans outstanding involving indirect country risk totaled $30.2 million, or 2.7% of the Company’s total loans, and loans and commitments involving indirect country risk totaled $109.9 million, or 8% of the Company’s total loans and commitments. “Indirect country risk” is defined as the risk associated with loans to such U.S. businesses, which are dependent upon foreign countries for business and trade. Of the $109.9 million in total loans and commitments involving indirect country risk, approximately 72% involve borrowers doing business with Korea, with the remaining percentages to other individual Pacific Rim countries being relatively small in relation to the total indirect loans involving country risk. As a result, with the exception of South Korea, the Company does not believe it has significant indirect country risk exposure to any other specific Pacific Rim country.
Of the total loans outstanding and commitments involving indirect country risk identified above, approximately 80% of such loans and commitments were to businesses which import goods from Korea and 12% were loans or commitments to businesses which export goods to Korea.
The potential risks to the Company differ depending upon whether the customer is in the export or the import business. The primary manner in which adverse changes in the economic conditions in the relevant Pacific Rim countries would affect business customers in the export business is a decrease in the volume in their respective businesses. As a result, the Company’s volume of such loans would tend to decrease due to lower demand. In addition, export loans are generally dependent on the businesses’ cash flows and thus may be subject to adverse conditions in the general economy of the country or countries with which the customer does its exporting business. The Company’s import loans are generally to U.S. domestic business entities whose operations would not be directly affected by the economic conditions of foreign countries, as importers can typically obtain goods from an alternative market if necessary, so the effect on the borrower’s business is less significant.
The Company limits its risk exposure with respect to export loans by participating in the state and federal agency supported export programs such as the Export Working Capital Program and the California Export Finance Office, which guarantee 70 to 90% of the export loans. The Company also requires that a majority of export finance loans are supported by letters of credit issued by established creditworthy commercial banks. The Company also monitors other foreign countries for economic or political risks to the portfolio. As part of its loan loss allowance methodology, the Company assigns one of three rating factors to borrowers in these businesses, depending upon the perceived degree of indirect country risk and allocates an additional amount to the allowance to reflect the potential additional risk from such indirect exposure to the economies of those foreign countries.
Nonperforming Assets
Nonperforming assets are comprised of loans on nonaccrual status, loans 90 days or more past due but not on nonaccrual status, loans restructured where the terms of repayment have been renegotiated, resulting in a reduction and/or deferral of interest or principal, and Other Real Estate Owned (“OREO”). Management generally places loans on nonaccrual status when they become 90 days or more past due, unless they are fully secured and in process of collection. Loans may be restructured in the discretion of Management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms, but the Company nonetheless believes the borrower will eventually overcome those circumstances and repay the loan in full. OREO consists of real property acquired through foreclosure or similar means that Management intends to offer for sale.
Management’s classification of a loan as nonaccrual or restructured is an indication that there is reasonable doubt as to the full collectibility of principal and/or interest on the loan. At this point, the Company stops recognizing income from the interest on the loan and reverses any uncollected interest that had been accrued but unpaid. If the loan deteriorates further due to a borrower’s bankruptcy or similar financial problems, unsuccessful collection efforts or a loss classification by regulators or auditors, the remaining balance of the loan is then charged off. These loans may or may not be collateralized, but collection efforts are continuously pursued. Total nonperforming loans were $3.0 million and $3.4 million as of June 30, 2005 and December 31, 2004. The decrease in nonperforming loans was mainly due to a $250,000 decrease in SBA loans. Total nonperforming loans also decreased by $120,000 to $3.0 million in the first half of 2005 from $3.2 million in the first half of 2004. This decrease was primarily due to a $1.9 million decrease in nonperforming commercial business loans. This decrease was partially offset by $1.7 million increase nonperforming construction loans.
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The following table provides information with respect to the components of the Company’s nonperforming assets as of the dates indicated:
June 30, 2005 | December 31, 2004 | |||||||
(Dollars in Thousands) | ||||||||
Nonaccrual loans: | ||||||||
Real estate: | ||||||||
Construction | $ | 1,695 | $ | 1,746 | ||||
Commercial | — | — | ||||||
Commercial: | ||||||||
Korean Affiliate Loans | — | — | ||||||
Other commercial loans | 900 | 957 | ||||||
Consumer | 67 | 108 | ||||||
Trade finance: | ||||||||
Korean Affiliate Loans | — | — | ||||||
Other trade finance loans | — | — | ||||||
SBA | 370 | 620 | ||||||
Other23 | — | — | ||||||
Total | 3,032 | 3,431 | ||||||
Loans 90 days or more past due (as to principal or interest) still accruing: | ||||||||
Total | — | — | ||||||
Restructured loans:24 | ||||||||
Total | — | — | ||||||
Total nonperforming loans | 3,032 | 3,431 | ||||||
Other real estate owned | — | — | ||||||
Total nonperforming assets | $ | 3,032 | $ | 3,431 | ||||
Nonperforming loans as a percentage of total loans | 0.27 | % | 0.34 | % | ||||
Nonperforming assets as a percentage of total loans and other real estate owned | 0.27 | % | 0.34 | % | ||||
Allowance for loan losses to nonperforming loans | 413.58 | % | 327.22 | % |
The Company evaluates impairment of loans according to the provisions of SFAS No. 114,Accounting by Creditors for Impairment of a Loan. Under SFAS No. 114, loans are considered impaired when it is probable that the Company will be unable to collect all amounts due as scheduled according to the contractual terms of the loan agreement, including contractual interest and principal payments. Impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate or, alternatively, at the loan’s observable market price or the fair value of the collateral if the loan is collateralized, less costs to sell.
23 | Consists of transactions in process and overdrafts |
24 | A “restructured loan” is one the terms of which were renegotiated to provide a reduction or deferral of interest or principal because of deterioration in the financial position of the borrower. |
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The following table provides information on impaired loans for the periods indicated:
June 30, 2005 | December 31, 2004 | |||||||
(Dollars in thousands) | ||||||||
Impaired loans with specific reserves | $ | 2,287 | $ | 2,616 | ||||
Impaired loans without specific reserves | 3,134 | 2,490 | ||||||
Total impaired loans | 5,421 | 5,106 | ||||||
Allowance on impaired loans | (179 | ) | (398 | ) | ||||
Net recorded investment in impaired loans | $ | 5,242 | $ | 4,711 | ||||
Average total recorded investment in impaired loans | $ | 4,895 | $ | 6,520 | ||||
Interest income recognized in impaired loans on a cash basis | $ | 111 | $ | 234 |
Allowance for Loan Losses
The allowance for loan losses reflects Management’s judgment of the level of allowance adequate to provide for probable losses inherent in the loan portfolio as of the balance sheet date. On a quarterly basis, the Company assesses the overall adequacy of the allowance for loan losses, utilizing a disciplined and systematic approach which includes the application of a specific allowance for identified problem loans, a formula allowance for identified graded loans, an allocated allowance for large groups of smaller balance homogenous loans, and an allocated allowance for country risk exposure.
Allowance for Specifically Identified Problem Loans. The specific allowance is determined based on the present value of expected future cash flows discounted at the loan’s effective interest rate, except that as a practical expedient, the Company may measure impairment based on a loan’s observable market price, or the fair value of the collateral if the loan is collateral dependent. Regardless of the measurement method, the Company measures impairment based on the fair value of the collateral when it is determined that foreclosure is probable.
Formula Allowance for Identified Graded Loans. Non-homogenous loans such as commercial real estate, construction, commercial business, trade finance and SBA loans that are not impaired are reviewed individually and subject to a formula allowance. The formula allowance is calculated by applying loss factors to outstanding pass, special mention, substandard, and doubtful loans. The evaluation of inherent loss for these loans involves a high degree of uncertainty, subjectivity, and judgment, because probable loan losses are not identified with specific loan. In determining the formula allowance, Management relies on a mathematical calculation that incorporates a twelve-quarter rolling average of historical losses.
In order to reflect the impact of recent events, the twelve-quarter rolling average is weighted. Loans risk-rated pass, special mention and substandard for the most recent three quarters are adjusted to an annual basis as follows:
• | The most recent quarter is weighted 4/1; |
• | The second most recent is weighted 4/2; and |
• | The third most recent is weighted 4/3. |
The formula allowance may be further adjusted to account for the following qualitative factors:
• | Changes in lending policies and procedures, including underwriting standards and collection, charge-off, and recovery practices; |
• | Changes in national and local economic and business conditions and developments, including the condition of various market segments; |
• | Changes in the nature and volume of the loan portfolio; |
• | Changes in the experience, ability, and depth of lending management and staff; |
• | Changes in the trend of the volume and severity of past due and classified loans, and trends in the volume of nonaccrual loans and troubled debt restructurings, and other loan modifications; |
• | Changes in the quality of our loan review system and the degree of oversight by the Board of Directors; |
• | The existence and effect of any concentrations of credit, and changes in the level of such concentrations; and |
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• | The effect of external factors such as competition and legal and regulatory requirements on the level of estimated losses in our loan portfolio. |
Allowance for Large Groups of Smaller Balance Homogeneous Loans. The portion of the allowance allocated to large groups of smaller balance homogenous loans is focused on loss experience for the pool rather than on analyses of individual loans. Large groups of smaller balance homogenous loans consist of consumer loans to individuals. The allowance for groups of performing loans is based on historical losses over a three-year period. In determining the level of allowance for delinquent groups of loans, the Company classifies groups of homogenous loans based on the number of days delinquent.
Allowance for Country Risk Exposure.The allowance for country risk exposure is based on an estimate of probable losses relating to both direct exposure to the Korean economy, and indirect exposure to the economies of various Pacific Rim countries. The exposure is related to trade finance loans made to support export/import businesses between U.S. and Korea, Korean Affiliate Loans, and certain loans to local U.S. businesses that are supported by stand by letters of credit issued by Korean banks. As with the credit rating system, the Company uses a country risk grading system under which risk gradings have been divided into three ranks. To determine the risk grading, the Company evaluates loans to companies with a significant portion of their business reliant upon imports or exports to Pacific Rim countries. The Company then analyzes the degree of dependency on business, suppliers or other business areas dependent upon such countries and applies an individual rating to the credit. The Company provides an allowance for country risk exposure based upon the rating of dependency. Most of the Company’s business customers whose operations are indirectly affected by the economies of such countries are in the import or export businesses. As part of its methodology, the Company assigns one of three rating factors (25, 50 or 75 basis points) to borrowers in these businesses, depending upon the perceived degree of indirect exposure to such economies. The “country risk exposure factor” reflected in the table below is in addition to the allowance for such loans, which is already reflected, in the formula allowance. This factor takes into account both the direct risk on the loans included in the Loans Involving Country Risk table above, and the loans to import or export businesses involving indirect exposure to the Korean economy.
The process of assessing the adequacy of the allowance for loan losses involves judgmental discretion, and eventual losses may differ from even the most recent estimates. Further, the Company’s independent loan review consultants, as well as the Company’s external auditors, the FDIC and the California Department of Financial Institutions, review the allowance for loan losses as an integral part of their examination process.
The following table sets forth the composition of the allowance for loan losses as of June 30, 2005 and December 31, 2004:
Composition of Allowance for Loan Losses
As of June 30, | As of December 31, | |||||
(Dollars in thousands) | ||||||
Specific (Impaired loans) | $ | 179 | $ | 398 | ||
Formula (non-homogeneous) | 11,756 | 10,282 | ||||
Homogeneous | 312 | 269 | ||||
Country risk exposure | 291 | 278 | ||||
Total allowance for loan losses | $ | 12,538 | $ | 11,227 | ||
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The table below summarizes the activity in the Company’s allowance for loan losses for the periods indicated:
Allowance for Loan Losses
(Dollars in thousands) | ||||||||||||
June, 30 2005 | December 31, 2004 | June, 30 2004 | ||||||||||
Balances: | ||||||||||||
Average total loans outstanding during period25 | $ | 1,059,963 | $ | 878,819 | $ | 818,427 | ||||||
Total loans outstanding at end of period25 | $ | 1,122,790 | $ | 1,021,359 | $ | 879,224 | ||||||
Allowance for Loan Losses: | ||||||||||||
Balance at beginning of period | $ | 11,227 | $ | 8,804 | $ | 8,804 | ||||||
Charge-offs: | ||||||||||||
Real estate | ||||||||||||
Construction | — | 435 | 435 | |||||||||
Commercial | — | — | — | |||||||||
Commercial: | ||||||||||||
Korean Affiliate Loans | — | — | — | |||||||||
Other commercial loans | 309 | 967 | 155 | |||||||||
Consumer | 117 | 165 | 80 | |||||||||
Trade Finance: | ||||||||||||
Korean Affiliate Loans | — | — | — | |||||||||
Other trade finance loans | — | — | — | |||||||||
SBA | 2 | 63 | 9 | |||||||||
Other | — | — | — | |||||||||
Total Charge-offs: | 428 | 1,630 | 679 | |||||||||
Recoveries: | ||||||||||||
Real estate | ||||||||||||
Construction | — | — | — | |||||||||
Commercial | — | — | — | |||||||||
Commercial: | ||||||||||||
Korean Affiliate Loans | — | — | — | |||||||||
Other commercial loans | 15 | 696 | 375 | |||||||||
Consumer | 11 | 35 | 34 | |||||||||
Trade Finance: | ||||||||||||
Korean Affiliate Loans | — | — | — | |||||||||
Other trade finance loans | — | 41 | 41 | |||||||||
SBA | 13 | 31 | 19 | |||||||||
Other | — | — | — | |||||||||
Total recoveries | 39 | 803 | 469 | |||||||||
Net loan charge-offs and (recoveries) | 389 | 827 | 210 | |||||||||
Provision for loan losses | 1,700 | 3,250 | 1,450 | |||||||||
Balance at end of period | $ | 12,538 | $ | 11,227 | $ | 10,044 | ||||||
Ratios: | ||||||||||||
Net loan charge-offs to average total loans | 0.04 | % | 0.09 | % | 0.03 | % | ||||||
Provision for loan losses to average total loans | 0.16 | 0.37 | 0.17 | |||||||||
Allowance for loan losses to gross loans at end of period | 1.12 | 1.10 | 1.14 | |||||||||
Allowance for loan losses to total nonperforming loans | 413.58 | 327.22 | 318.65 | |||||||||
Net loan charge-offs to allowance for loan losses at end of period | 3.10 | 7.37 | 2.09 | |||||||||
Net loan charge-offs to provision for loan losses | 22.88 | % | 25.45 | % | 14.51 | % |
The allowance for loan losses was $12.5 million as of June 30, 2005 compared to $11.2 million at December 31, 2004. The Company recorded a provision of $1.7 million for the first half of 2005. For the six months ended June 30, 2005, the Company charged off $428,000 and recovered $39,000, resulting in net charge-offs of $389,000, compared to net charge-offs of $210,000 for the same period in 2004. The allowance for loan losses increased to 1.12% of total gross loans at June 30, 2005, as compared to 1.10% at December 31, 2004. In comparison to June 30, 2004, the allowance for loan losses slightly decreased to 1.12 as compared to 1.14%. The Company provides an allowance for the new credits based on the migration analysis discussed previously. Because
25 | Total loans are net of deferred loan fees and discount on SBA loans sold. |
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of the improving quality of assets, the ratio of the allowance for loan losses to total nonperforming loans increased to 413.6% as of June 30, 2005 compared to 327.2% as of December 31, 2004 and 318.7% at June 30, 2004. Management believes that the ratio of the allowance to nonperforming loans at June 30, 2005 was adequate based on its overall analysis of the loan portfolio.
The balance of the allowance for loan losses increased to $12.5 million as of June 30, 2005 compared to $11.2 million as of December 31, 2004. This increase was mainly due to an $1.5 million increase in formula (non-homogeneous) allowance, a $44,000 increase in homogeneous allowance and a $12,000 increase in country risk exposure mainly due to loan growth. These increases were partially offset by a decrease in the specific reserve of $219,000.
The provision for loan losses for the first half of 2005 was $1.7 million, an increase of 17%, compared to $1.5 million for the same period in 2004. This increase was due to loan growth.
Management believes the level of allowance as of June 30, 2005 is adequate to absorb the estimated losses from any known or inherent risks in the loan portfolio and the loan growth for the quarter. However, no assurance can be given that economic conditions which adversely affect our service areas or other circumstances may not require increased provisions for loan losses in the future.
Management is committed to maintaining the allowance for loan losses at a level that is considered commensurate with estimated and known risks in the portfolio. Although the adequacy of the allowance is reviewed quarterly, Management performs an ongoing assessment of the risks inherent in the portfolio. Real estate is the principal collateral for the Company’s loans.
Other Assets
Other assets were $4.1 million at June 30, 2005 and $4.0 million at December 31, 2004.
Deposits
An important balance sheet component affecting the Company’s net interest margin is its deposit base. The Company’s average interest bearing deposit cost increased to 2.52% during the first six months of 2005, compared to 1.88% for the same period of 2004. This increase is primarily due to the increases in short term rates set by the Federal Reserve Board, which caused the average rates paid on deposits and other liabilities to increase.
The Company can deter, to some extent, the rate hunting customers who demand high cost CDs because of local market competition by using wholesale funding sources. Total brokered CDs were $20.0 million as of June 30, 2005, and December 31, 2004, with maturities ranging from ten to twelve months. With interest rates relatively low, the Company has extended the duration of its liabilities using wholesale funding sources to protect its net interest margin going forward in the event that interest rates begin to rise. In addition, the Company maintained an $80.0 million time certificate of deposit with the State of California as of June 30, 2005, which increased by $20 million as compared to $60 million at December 31, 2004. The deposit has been renewed every 3 to 6 months.
Total deposits increased by $155.2 million or 13% to $1.32 billion at June 30, 2005 compared to $1.17 billion at December 31, 2004. The increase was mainly due to a $40.0 million increase in non-interest bearing deposits and an $81.1 million increase in time deposits of $100,000 or more. Money market and NOW deposits and savings also increased by 12% and 9%, respectively, to $235.4 million and $80.3 million, respectively from $210.8 million and $73.7 million, respectively, at December 31, 2004. The Company introduced a new deposit product called Summer CDs in June 2005, which contributed to deposit growth.
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Deposits consist of the following as of the dates indicated:
June, 30 2005 | December, 31, 2004 | |||||
(Dollars in Thousands) | ||||||
Demand deposits (noninterest-bearing) | $ | 387,183 | $ | 347,195 | ||
Money market accounts and NOW | 235,433 | 210,842 | ||||
Savings | 80,334 | 73,733 | ||||
702,950 | 631,770 | |||||
Time deposits: | ||||||
Less than $100,000 | 84,296 | 81,407 | ||||
$100,000 or more | 533,483 | 452,359 | ||||
617,779 | 533,766 | |||||
Total | $ | 1,320,729 | $ | 1,165,536 | ||
Time deposits by maturity dates are as follows at June 30, 2005:
$100,000 or Greater | Less Than $100,000 | Total | |||||||
(Dollars in thousands) | |||||||||
2005 | $ | 383,292 | $ | 55,116 | $ | 438,408 | |||
2006 | 142,025 | 26,751 | 168,776 | ||||||
2007 | 3,013 | 1,626 | 4,639 | ||||||
2008 | 3,849 | 573 | 4,422 | ||||||
2009 and thereafter | 1,304 | 230 | 1,534 | ||||||
Total | $ | 533,483 | $ | 84,296 | $ | 617,779 | |||
Information concerning the average balance and average rates paid on deposits by deposit type for the three and six months ended June 30, 2005 and 2004 is contained in the “Distribution, Yield and Rate Analysis of Net Income” tables above in the section entitled “Net Interest Income and Net Interest Margin.”
Other Borrowed Funds
The Company regularly uses Federal Home Loan Bank of San Francisco (“FHLB”) advances and short-term borrowings, which consist of notes issued to the U.S. Treasury to manage Treasury Tax and Loan payments. The Company’s outstanding FHLB borrowing was $47.2 million and $42.4 million, at June 30, 2005 and December 31, 2004, respectively. This increase was due to Management’s decision to fund loan growth by increasing FHLB advances. Notes issued to the U.S. Treasury amounted $1.2 million as of June 30, 2005 compared to $2.2 million as of December 31, 2004. The total borrowed amount outstanding at June 30, 2005 and December 31, 2004 was $48.5 million and $44.9 million, respectively.
In addition, the issuance of long-term subordinated debenture at the end of 2003 of $18.0 million in “pass-through” trust preferred securities created another source of funding.
Contractual Obligations
The following table presents, as of June 30, 2005, the Company’s significant fixed and determinable contractual obligations, within the categories described below, by payment date. These contractual obligations, except for the operating lease obligations,
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are included in the Consolidated Statements of Financial Condition. The payment amounts represent those amounts contractually due to the recipient.
Payments Due by Period | |||||||||||||||
Less than 1 year | 1-3 years | 3-5 years | After 5 years | Total | |||||||||||
(Dollars in Thousands) | |||||||||||||||
Debt obligations * | $ | 41,289 | $ | 4,000 | $ | — | $ | 21,806 | $ | 67,095 | |||||
Deposits | 1,270,544 | 42,722 | 7,463 | — | 1,320,729 | ||||||||||
Operating lease obligations | 1,076 | 3,286 | 1,303 | 1,895 | 7,561 | ||||||||||
Total contractual obligations | $ | 1,312,909 | $ | 50,008 | $ | 8,767 | $ | 23,701 | $ | 1,395,385 | |||||
* | Includes principal payment only |
LIQUIDITY AND MARKET RISK/INTEREST RISK MANAGEMENT
Liquidity
Liquidity is the Company’s ability to maintain sufficient cash flow to meet deposit withdrawals and loan demands and to take advantage of investment opportunities as they arise. The Company’s principal sources of liquidity have been growth in deposits, proceeds from the maturity of securities, and repayments from loans. To supplement its primary sources of liquidity, the Company maintains contingent funding sources, which include a borrowing capacity of up to 25% of total assets upon providing collateral with the Federal Home Loan Bank of San Francisco, access to the discount window of the Federal Reserve Bank of San Francisco, a deposit facility with the California State Treasurers office up to 50% of total equity with collateral pledging, and unsecured Fed funds lines with correspondent banks.
As of June 30, 2005, the Company’s liquidity ratio, which is the ratio of available liquid funds to net deposits and short-term liabilities was 18%. Total available liquidity as of that date was $238.9 million, consisting of excessive cash holdings or balances in due from banks, overnight Fed funds sold, money market funds and unpledged available for sale securities. It is the Company’s policy to maintain a minimum liquidity ratio of at least 10%. The Company’s net non-core fund dependence ratio was 39% under applicable regulatory guidelines, which assumes all certificates of deposit over $100,000 (“Jumbo CD’s”) as volatile sources of funds. The Company has identified approximately $40 million of Jumbo CD’s as stable and core sources of funds based on past historical analysis. The net non-core fund dependence ratio was 40% with the assumption of $40 million as stable and core fund sources and certain portion of MMDA as volatile. The net non-core fund dependence ratio is the ratio of net short-term investment less non-core liabilities divided by the long-term assets.
Market Risk/Interest Rate Risk Management
Market risk is the risk of loss from adverse changes in market prices and rates. The Company’s market risk arises primarily from interest rate risk inherent in its lending, investment and deposit taking activities. The Company’s profitability is affected by fluctuations in interest rates. A sudden and substantial change in interest rates may adversely impact the Company’s earnings to the extent that the interest rates borne by assets and liabilities do not change at the same speed, to the same extent or on the same basis. To that end, Management actively monitors and manages its interest rate risk exposure.
Asset/liability management is concerned with the timing and magnitude of the repricing of assets and liabilities. The Company actively monitors its assets and liabilities to mitigate risks associated with interest rate movements. In general, the Management’s strategy is to match asset and liability balances within maturity categories to limit the Company’s exposure to earnings fluctuations and variations in the value of assets and liabilities as interest rates change over time. The Company’s strategy for asset/liability management is formulated and monitored by the Company’s Asset/Liability Management Board Committee. This Board Committee is composed of four outside directors and the President. The Chief Financial Officer serves as a secretary of the Committee. The Board Committee meets quarterly to review and adopt recommendations of the Asset/Liability Management Committee.
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The Asset/Liability Management Committee consists of executive and manager level officers from various areas of the Company including lending, investment, and deposit gathering, in accordance with policies approved by the Board of Directors. The primary goal of the Company’s Asset/Liability Management Committee is to manage the financial components of the Company to optimize the net income under varying interest rate environments. The focus of this process is the development, analysis, implementation, and monitoring of earnings enhancement strategies, which provide stable earnings and capital levels during periods of changing interest rates.
The Asset/Liability Management Committee meets regularly to review, among other matters, the sensitivity of the Company’s assets and liabilities to interest rate changes, the book and market values of assets and liabilities, unrealized gains and losses, and maturities of investments and borrowings. The Asset/Liability Management Committee also approves and establishes pricing and funding decisions with respect to overall asset and liability composition, and reports regularly to the Asset/Liability Board Committee and the Board of Directors.
Interest Rate Risk
Interest rate risk occurs when assets and liabilities reprice at different times as interest rates change. In general, the interest that the Company earns on its assets and pays on its liabilities are established contractually for specified period of time. Market interest rates change over time and if a financial institution cannot quickly adapt to changes in interest rate, it may be exposed to volatility in earnings. For instance, if the Company were to fund long-term fixed rate assets with short-term variable rate deposits, and interest rates were to rise over the term of the assets, the short-term variable deposits would rise in cost, adversely affecting net interest income. Similar risks exist when rate sensitive assets (for example, prime rate based loans) are funded by longer-term fixed rate liabilities in a falling interest rate environment.
In order to monitor and manage interest rate risk, Management utilizes quarterly gap analysis and quarterly simulation modeling as a tool to determine the sensitivity of net interest income and economic value sensitivity of the balance sheet. These techniques are complementary and both are used to provide a more accurate measurement of interest rate risk.
Gap analysis measures the repricing mismatches between assets and liabilities. The interest rate sensitivity gap is determined by subtracting the amount of liabilities from the amount of assets that reprice during a particular time interval. A liability sensitive position results when more liabilities than assets reprice or mature within a given period. Conversely, an asset sensitive position results when more assets than liabilities reprice within a given period. As of June 30, 2005, the Company was asset sensitive with a positive one-year gap of $236.3 million or 15.7% of total assets and 17.3% of earning assets.
Although the interest rate sensitivity gap analysis is a useful measurement tool and contributes to effective asset/liability management, it is difficult to predict the effect of changing interest rates based solely on that measure. As a result, the Asset/Liability Management Committee also uses simulation modeling on a quarterly basis as a tool to measure the sensitivity of earnings and economic value of equity (“EVE”) to interest rate changes. EVE is defined as the net present value of an institution’s existing assets, minus the present value of liabilities and off-balance sheet instruments. The simulation model captures all assets, liabilities, and off-balance sheet financial instruments, such as the interest rate swaps, and other significant variables considered to be affected by interest rates. These other significant variables include prepayment speeds on mortgage-backed securities, cash flows on loans and deposits, principal amortization, call options on investment securities purchased, balance sheet growth assumptions, and changes in interest rate relationships as various rate indices react differently to market rates. The simulation measures the volatility of net interest income and net portfolio value under immediate rising or falling market rate scenarios in 100-basis-point increments up to 300 basis points.
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The following table sets forth, as of June 30, 2005, the estimated impact of changes on the Company’s net interest income over a twelve-month period and EVE, assuming a parallel shift of 100 to 300 basis points in both directions.
Change (In Basis Points) | Net Interest Income (Next twelve months) | % Change | Economic Value of Equity (EVE) | % Change | ||||||||
(Dollars in thousands) | ||||||||||||
+300 | $ | 77,961 | 18.56 | % | $ | 99,651 | -3.82 | % | ||||
+200 | $ | 73,934 | 12.44 | % | $ | 100,988 | -2.53 | % | ||||
+100 | $ | 69,852 | 6.23 | % | $ | 102,329 | -1.24 | % | ||||
Level | $ | 65,755 | 0.00 | % | $ | 103,613 | 0.00 | % | ||||
-100 | $ | 61,557 | -6.38 | % | $ | 104,766 | 1.11 | % | ||||
-200 | $ | 57,021 | -13.28 | % | $ | 103,350 | 1.68 | % | ||||
-300 | $ | 50,132 | -23.76 | % | $ | 105,661 | 1.98 | % |
As previously indicated, net income increases (decreases) as market interest rates rise (fall), since the Company is asset sensitive. The EVE decreases (increases), as the rate rises (falls), since the EVE has a negative convexity (reverse relationship) with the discount rate. As the above table indicates, a 300 basis points drop in rates impacts net interest income by $15.6 million or a 24% decrease, whereas a rate increase of 300 basis points impacts net interest income by only $12.2 million or a 19% increase.
All interest-earning assets and interest-bearing liabilities and related derivative contracts are included in the rate sensitivity analysis at June 30, 2005. At June 30, 2005, the Company’s estimated changes in net interest income and EVE was within the ranges established by the Board of Directors.
The primary analytical tool used by the Company to gauge interest rate sensitivity is a simulation model used by many community banks, which is based upon the actual maturity and repricing characteristics of interest-rate-sensitive assets and liabilities. The model attempts to forecast changes in the yields earned on assets and the rates paid on liabilities in relation to changes in market interest rates. As an enhancement to the primary simulation model, other factors are incorporated into the model, including prepayment assumptions and market rates of interest provided by independent broker/dealer quotations, an independent pricing model, and other available public information. The model also factors in projections of anticipated activity levels of the Company product lines. Management believes that the assumptions it uses to evaluate the vulnerability of the Company’s operations to changes in interest rates approximate actual experience and considers them reasonable; however, the interest rate sensitivity of the Company’s assets and liabilities and the estimated effects of changes in interest rates on the Company’s net interest income and EVE could vary substantially if different assumptions were used or if actual experience were to differ from the historical experience on which they are based.
Shareholders’ equity as of June 30, 2005 was $101.2 million, compared to $90.7 million as of December 31, 2004. The primary sources of increases in capital have been retained earnings and relatively nominal proceeds from the exercise of employee incentive and/or nonqualified stock options. Shareholders’ equity is also affected by increases and decreases in unrealized losses on securities classified as available-for-sale. The Company is committed to maintaining capital at a level sufficient to assure shareholders, customers, and regulators that the Company is financially sound and able to support its growth from its retained earnings.
The Company is subject to risk-based capital regulations adopted by the federal banking regulators. These guidelines are used to evaluate capital adequacy and are based on an institution’s asset risk profile and off-balance sheet exposures. The risk-based capital guidelines assign risk weightings to assets both on and off-balance sheet and place increased emphasis on common equity. According to the regulations, institutions whose Tier I risk based capital ratio, total risk based capital ratio and leverage ratio meet or exceed 6%, 10%, and 5%, respectively, are deemed to be “well-capitalized.” All of the Company’s capital ratios were well above the minimum regulatory requirements for a “well-capitalized” institution.
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The following table compares the Company’s and Bank’s actual capital ratios at June 30, 2005, to those required by regulatory agencies for capital adequacy and well-capitalized classification purposes:
Risk Based Ratios
Center Financial Corporation | Center Bank | Minimum Regulatory Requirements | Well Capitalized Requirements | |||||||||
Total Capital (to Risk-Weighted Assets) | 11.25 | % | 11.18 | % | 8.00 | % | 10.00 | % | ||||
Tier 1 Capital (to Risk-Weighted Assets) | 10.13 | % | 10.06 | % | 4.00 | % | 6.00 | % | ||||
Tier 1 Capital (to Average Assets) | 8.61 | % | 8.58 | % | 4.00 | % | 5.00 | % |
Item 3: | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
The information concerning quantitative and qualitative disclosures about market risk is included as part of Part I, Item 2 above. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations –Liquidity and Market Risk/Interest Rate Risk Management”.
Item 4: | CONTROLS AND PROCEDURES |
Evaluation of Disclosure Controls and Procedures. Disclosure controls and procedures are designed to ensure that information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by the Company in the reports that it files under the Exchange Act is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer as appropriate to allow timely decisions regarding required disclosure.
Because of inherent limitations in any internal control, no matter how well designed, misstatements due to error or fraud may occur and not be detected, including the possibility of the circumvention or overriding of controls. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, internal control effectiveness may vary over time.
The Company’s Chief Executive Officer and its Chief Financial Officer, after evaluating the effectiveness of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13(a)-15(e) as of the end of the period covered by this report (the “Evaluation Date”)) have concluded that as of the Evaluation Date, the Company’s disclosure controls and procedures were effective.
As reported in the Company’s Form 10-K for its fiscal year ended December 31, 2004, management had concluded that, as of December 31, 2004, the Company’s disclosure controls and procedures were ineffective due to an internal control deficiency that constituted a “material weakness,” as defined by the Public Company Accounting Oversight Board’s Accounting Standard No. 2. The identified weakness was that the Company failed to design and implement controls related to the interpretation and implementation of various accounting principles, primarily related to complex non-routine business transactions. Specifically, the Company did not have personnel with the requisite expertise and training or utilize outside consulting expertise with respect to the application of these accounting principles. As a result, as of December 31, 2004, certain audit adjustments related to non-routine business transactions involving financial instruments and the sale of SBA loans, which were not material to the interim or annual financial statements in the aggregate, were necessary to present the financial statements in accordance with generally accepted accounting principles accepted in the United States. The Company subsequently remediated the deficiency in its internal control over financial reporting, and in so doing also remediated the deficiency in its disclosure controls and procedures by implementing the changes discussed below. After these remedial measures and a re-evaluation of the Company’s disclosure controls and procedures, the Company’s Chief Executive Officer and Chief Financial Officer concluded that its disclosure controls and procedures were effective as of the Evaluation Date.
Changes in Internal Controls. There were no significant changes, other than as discussed below, in the Company’s internal controls over financial reporting or in other factors in the second quarter of 2005 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.
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To correct the material weakness identified above, the Company has augmented its internal accounting staff to enable the Company to properly apply these complex accounting principles to its financial statements. On March 17, 2005, the Company hired Patrick Hartman, a certified public accountant with more than 28 years of experience in the financial services industry, as its new chief financial officer. The Company has also expanded its external consulting expertise by retaining Meloni Hribal Tratner, LLP, a certified public accounting firm, as a third party consultant to provide prospective guidance with respect to complex accounting principles before the Company’s financial statements are reviewed by its independent registered public accountants. In addition, as discussed more fully in its report on Form 10-K for its fiscal year ended December 31, 2004, the Company has implemented updated policies and procedures which enabled its interest swaps to qualify for hedge accounting beginning in second quarter of 2005.
Item 1: | LEGAL PROCEEDINGS |
From time to time, we are a party to claims and legal proceedings arising in the ordinary course of our business. With the exception of the potentially adverse outcome in the litigation described in the next two paragraphs, after taking into consideration information furnished by our counsel as to the current status of these claims and proceedings, we do not believe that the aggregate potential liability resulting from such proceedings would have a material adverse effect on our financial condition or results of operation.
On or about March 3, 2003, the Bank was served with a complaint filed by Korea Export Insurance Corporation (“KEIC”) in Orange County, California Superior Court, entitled Korea Export Insurance Corporation v. Korea Data Systems (USA), Inc., et al. KEIC is seeking to recover alleged losses from a number of parties involved in international trade transactions that gave rise to bills of exchange financed by various Korean Banks but not ultimately paid. KEIC is seeking to recover damages of approximately $56 million from us based on a claim that we, in our capacity as a presenting bank for these bills of exchange, acted negligently in presenting and otherwise handling trade documents for collection. The Bank answered KEIC’s complaint denying liability, and has asserted claims against various other parties seeking indemnification to the extent it may be found liable, and also seeking damages. Other parties against whom the Bank has made claims have made tort liability and indemnification claims against the Bank (and other parties in the case). None of the claims against us or the other parties has yet been adjudicated. The parties are continuing to conduct discovery, and the litigation is still in the preliminary stages. We are vigorously defending this lawsuit.
We believe that we have meritorious defenses against the claims made by KEIC and the parties alleged to have accepted the bills of exchange subject to the lawsuit. However, we cannot predict the outcome of this litigation, and it will be expensive and time-consuming to defend. One of the Bank’s insurance companies, BancInsure, has informed the Bank that there is coverage for a portion of defense. While it is possible that the claims may ultimately be determined to be covered by insurance, BancInsure has stated that it reserves its rights to determine whether coverage exists and ultimately deny coverage. If the outcome of this litigation is adverse to us, and we are required to pay significant monetary damages, our financial condition and results of operations are likely to be materially and adversely affected.
Item 2: | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS |
Not applicable
Item 3: | DEFAULTS UPON SENIOR SECURITIES |
Not applicable
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Item 4: | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS |
The Company’s annual meeting of shareholders was held on May 11, 2005. Proxies were solicited by the Company’s management pursuant to Regulation 14 under the Securities Exchange Act of 1934. There was no solicitation in opposition to Management’s nominees for directorship as listed in the proxy statement, and all of such nominees were elected pursuant to the vote of shareholders. The directors noted below were elected to two-year terms. The votes tabulated were:
Authority Given | Authority Withheld | |||
David Z. Hong | 13,902,506 | 307,647 | ||
Chang Hwi Kim | 14,076,081 | 134,072 | ||
Sang Hoon Kim | 14,076,081 | 134,072 | ||
Monica Yoon | 13,958,774 | 251,379 |
There were no broker non-votes received with respect to this item.
In addition, the terms of the following directors continued after the shareholders’ meeting:
Chung Hyun Lee | Jin Chul Jhung | Peter Y. S. Kim | Seon Hong Kim |
Item 5: | OTHER INFORMATION |
On August 3, 2005, the Company’s Audit Committee concluded that the Company will be required to restate its previously issued financial statements as of and for the years ended December 31, 2004, 2003 and 2002 and certain quarters during those years, and that these financial statements should not be relied upon. The Company filed a Current Report on Form 8-K with respect to this matter on August 9, 2005.
As discussed in the “Restatement” portion of Note 2 to the consolidated financial statements contained herein, the restatements for the periods mentioned relate to the accounting for the Company’s interest rate swaps, which were acquired from 2001 through 2003. These swaps had been accounted for using hedge accounting under FAS 133, “Accounting for Derivative Instruments and Hedging Activities,” the effectiveness of the hedges was documented using as a method known as the “short-cut method.” Management and the Audit Committee have concluded that this accounting treatment was not allowed by FAS 133. With respect to the income statements for the various periods, the restatements are expected to result in changes to reported income and expense. However, the Company expects that there will be no material effect on either the statements of financial condition or the cash flow statements for any of the periods involved.
At a meeting on June 15, 2005, the Audit Committee of Center Financial Corporation (the “Company”), Los Angeles, California, terminated Deloitte & Touche LLP as the Company’s principal independent accountant. At the same meeting, the Audit Committee selected the accounting firm of Grant Thornton LLP as the independent accountant for the Company’s 2005 fiscal year. The Company filed a report on Form 8-K concerning these matters on June 22, 2005 and amendments thereto on June 29, and August 2, 2005.
On May 10, 2005, Center Bank entered into a memorandum of understanding with the FDIC and the California Department of Financial Institutions (the “DFI”), which memorandum is an informal administrative action primarily with respect to the Bank’s compliance with Bank Secrecy Act (“BSA”) regulations. The memorandum requires the Bank to comply with the BSA and related rules and regulations in all material respects, and to take certain affirmative actions within various specified time frames to address the less than satisfactory BSA conditions identified in the Bank’s joint report of examination by the FDIC and the DFI dated February 22, 2005 (the “Examination Report”). Specifically, the memorandum requires the Bank to (i) implement a written action plan and various other policies and procedures, including comprehensive independent compliance testing, to ensure compliance with all BSA-related rules and regulations, in accordance with specific guidelines set forth in the memorandum; (ii) correct any apparent violations of the BSA and related regulations cited in the Examination Report; (iii) develop the expertise to ensure that generally accepted accounting principles and regulatory reporting guidelines are observed in all of the Bank’s financial transactions and reporting; and (iv) furnish written quarterly progress reports to the FDIC and the DFI detailing the form and manner of any actions taken to secure compliance with the memorandum and the results thereof.
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Management does not believe that the memorandum will have a material impact on our operating results or financial condition or that, unless we fail to adequately address the concerns of the FDIC, the memorandum will not constrain our business. Management is committed to resolving the issues addressed in the memorandum as promptly as possible, and has already taken numerous steps to address the identified deficiencies prior to executing the memorandum. The Company filed a Current Report on Form 8-K with respect to this matter on May 13, 2005.
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Item 6: | EXHIBITS |
Exhibit No. | Description | |
2.1 | Plan of Reorganization and Agreement of Merger dated June 7, 2002 among California Center Bank, Center Financial Corporation and CCB Merger Company1 | |
2.2 | Branch Purchase and Assumption Agreement dated January 7, 20042 | |
3.1 | Restated Articles of Incorporation of Center Financial Corporation1 | |
3.2 | Restated Bylaws of Center Financial Corporation1 | |
10.1 | Employment Agreement between California Center Bank and Seon Hong Kim dated March 30, 20043 | |
10.2 | Amended and Restated 1996 Stock Option Plan (assumed by Registrant in the reorganization)3 | |
10.3 | Lease for Corporate Headquarters Office1 | |
10.4 | Indenture dated as of December 30, 2003 between Wells Fargo Bank, National Association, as Trustee, and Center Financial Corporation, as Issuer2 | |
10.5 | Amended and Restated Declaration of Trust of Center Capital Trust I, dated as of December 30, 20032 | |
10.6 | Guarantee Agreement between Center Financial and Wells Fargo Bank, National Association dated as of December 30, 20032 | |
11 | Statement of Computation of Per Share Earnings (included in Note 7 to Consolidated Financial Statements included herein.) |
2 | Filed as an Exhibit to the Form 10-K filed with Securities and Exchange Commission on March 30, 2004 and incorporated herein by reference |
3 | Filed as an Exhibit to the Form 10-Q filed with Securities and Exchange Commission on May 14, 2004 and incorporated herein by reference |
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The Company has caused this report to be signed on its behalf by the undersigned thereunto duly authorized:
Date: August 15, 2005 | /s/ Seon Hong Kim | |||
Center Financial Corporation | ||||
Seon Hong Kim | ||||
President & Chief Executive Officer | ||||
Date: August 15, 2005 | /s/ Patrick Hartman | |||
Center Financial Corporation | ||||
Patrick Hartman | ||||
Executive Vice President & Chief Financial Officer |
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