BWC FINANCIAL CORP. CONSOLIDATED BALANCE SHEETS December 31 Assets 1998 1997 Cash and Due From Banks $14,345,000 $17,412,000 Federal Funds Sold 2,300,000 4,350,000 Other Short Term Investments 35,000 48,000 Total Cash and Cash Equivalents 16,680,000 21,810,000 Investment Securities: Available for Sale 45,655,000 33,062,000 Held to Maturity (approximate fair value of $13,797,000 in 1998 and $7,950,000 in 1997) 13,592,000 7,894,000 Loans, Net of Allowance for Credit Losses of $3,919,000 in 1998 and $2,936,000 in 1997. 183,058,000 161,002,000 Bank Premises and Equipment, Net 1,303,000 1,455,000 Interest Receivable and Other Assets 4,611,000 3,399,000 Total Assets $264,899,000 $228,622,000 Liabilities and Shareholder's Equity Liabilities Deposits: Noninterest-bearing $69,783,000 $59,354,000 Interest-bearing: Money Market Accounts 64,687,000 44,406,000 Savings and NOW Accounts 37,139,000 29,755,000 Time Deposits: Under $100,000 34,293,000 36,829,000 $100,000 or more 32,238,000 36,635,000 Total Interest-bearing 168,357,000 147,625,000 Total Deposits 238,140,000 206,979,000 Interest Payable and Other Liabilities 2,416,000 2,195,000 Total Liabilities 240,556,000 209,174,000 Commitments and Contingent Liabilities (Note 10) Shareholders' Equity Preferred Stock, no par value: 5,000,000 shares authorized, none outstanding. -- -- Common Stock, no par value: 25,000,000 shares authorized; issued and outstanding - 2,511,151 shares in 1998 and 1,233,051 in 1997. 19,002,000 18,603,000 Retained Earnings 5,006,000 706,000 Capital adjustment on available for sale securities 335,000 139,000 Total Shareholders' Equity 24,343,000 19,448,000 Total Liabilities and Shareholders' Equity $264,899,000 $228,622,000 <FN> The accompanying notes are an integral part of these consolidated statements. </FN> BWC FINANCIAL CORP. CONSOLIDATED STATEMENTS OF INCOME For the Year Ended December 31, 1998 1997 1996 Interest Income Loans, Including Fees $18,020,000 $16,107,000 $11,604,000 Investment Securities: Taxable 2,698,000 1,387,000 967,000 Non-taxable 504,000 391,000 495,000 Federal Funds Sold 421,000 383,000 154,000 Other Short Term Investments 219,000 48,000 18,000 Total Interest Income 21,862,000 18,316,000 13,238,000 Interest Expense Deposits 6,770,000 5,767,000 3,748,000 Federal Funds Purchased 4,000 3,000 16,000 Total Interest Expense 6,774,000 5,770,000 3,764,000 Net Interest Income 15,088,000 12,546,000 9,474,000 Provision For Credit Losses 825,000 1,125,000 650,000 Net Interest Income After Provision For Credit Losses 14,263,000 11,421,000 8,824,000 Noninterest Income BWC Mortgage Services - Commissions 3,744,000 2,077,000 1,367,000 BWC Mortgage Services - Fees & Other 376,000 175,000 127,000 Service Charges on Deposit Accounts 832,000 761,000 651,000 Other 787,000 705,000 566,000 Gains on Security Transactions 216,000 11,000 21,000 Total Noninterest Income 5,955,000 3,729,000 2,732,000 Noninterest Expense Salaries and Related Benefits 5,344,000 4,737,000 3,829,000 BWC Mortgage Services - Commissions 2,199,000 1,201,000 785,000 BWC Mortgage Services - Fees & Other 825,000 537,000 389,000 Occupancy 855,000 812,000 779,000 Furniture and Equipment 578,000 556,000 538,000 Other 2,961,000 2,401,000 2,178,000 Total Noninterest Expense 12,762,000 10,244,000 8,498,000 BWC Mortgage Services - Minority Interest 549,000 252,000 157,000 Income Before Income Taxes 6,907,000 4,654,000 2,901,000 Provision For Income Taxes 2,679,000 1,729,000 973,000 Net Income $4,228,000 $2,925,000 $1,928,000 Basic Earnings Per Share $1.70 $1.18 $0.71 Diluted Earnings Per Share $1.44 $1.03 $0.64 Average Basic Shares 2,487,730 2,475,075 2,712,615 Average Diluted Share Equivalents Related to Options 438,698 367,697 322,307 Average Diluted Shares 2,926,428 2,842,772 3,034,922 <FN> The accompanying notes are an integral part of these consolidated statements. </FN> BWC FINANCIAL CORP. CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY For the years ended December 31, 1998, 1997 and 1996 Accumulated Other Number Common Retained Comprehensive Comprehensive of Shares Stock Earnings Income Total Income Balance, January 1, 1996 935,907 $10,508,000 $4,257,000 $128,000 $14,893,000 Net Income for 1996 -- -- 1,928,000 -- 1,928,000 $1,928,000 Other Comprehensive Income, net of tax benefit of $74,000 -- -- -- (121,000) (121,000) (121,000) Comprehensive Income -- -- -- -- -- 1,807,000 10% Stock Dividend, Including Payment of fractional shares 92,835 1,950,000 (1,954,000) -- (4,000) Common Stock Issued and sold to the Defined Contribution Plan at $15.45 per share 11,736 181,000 -- -- 181,000 Repurchase and retirement of shares by the Corporation at $17.75 to $21.75 per share (23,880) (467,000) -- -- (467,000) Balance, December 31, 1996 1,016,598 12,172,000 4,231,000 7,000 16,410,000 Net Income for 1997 -- -- 2,925,000 -- 2,925,000 2,925,000 Other Comprehensive Income, net of tax liability of $68,000 -- -- -- 132,000 132,000 132,000 Comprehensive Income -- -- -- -- -- 3,057,000 10% Stock Dividend, Including Payment of fractional shares 101,882 2,521,000 (2,526,000) -- (5,000) Stock Options Exercised at $6.76 per share 4,300 29,000 -- -- 29,000 Repurchase and retirement of shares by the Corporation at $22.50 per share (1,650) (37,000) -- -- (37,000) 10% Stock Dividend, Including Payment of fractional shares 111,921 3,918,000 (3,924,000) -- (6,000) Balance, December 31, 1997 1,233,051 18,603,000 706,000 139,000 19,448,000 (CHANGES IN SHAREHOLDERS' EQUITY CONTINUED) Net Income for 1998 -- -- 4,228,000 -- 4,228,000 4,228,000 Other Comprehensive Income, net of tax liability of $134,000 -- -- -- 196,000 196,000 196,000 Comprehensive Income -- -- -- -- -- $4,424,000 Two for one Stock Split 1,248,832 -- -- -- Stock Options Exercised at $3.50 to $5.59 per share 15,741 57,000 -- -- 57,000 Common Stock Issued and sold to the Defined Contribution Plan at $24.06 per share 16,527 398,000 -- -- 398,000 Repurchase and retirement of shares by the Corporation at $18.25 to $19.00 per share (3,000) (56,000) -- -- (56,000) Adjustment for tax benefit resulting from the exercises of incentive stock options. -- -- 72,000 -- 72,000 Balance, December 31, 1998 2,511,151 $19,002,000 $5,006,000 $335,000 $24,343,000 <FN> The accompanying notes are an integral part of these consolidated statements. </FN> BWC FINANCIAL CORP. CONSOLIDATED STATEMENTS OF CASH FLOWS For the Year Ended December 31, 1998 1997 1996 Operating Activities: Net Income $4,228,000 $2,925,000 $1,928,000 Adjustments to reconcile net income to net cash provided: Amortization of loan fees (1,657,000) (1,383,000) (886,000) Provision for credit losses 825,000 1,125,000 650,000 Depreciation and amortization 416,000 403,000 386,000 Gain on sale of securities available-for-sale (216,000) (11,000) (21,000) Deferred income taxes (543,000) (575,000) (212,000) Increase in accrued interest receivable and other assets (669,000) (906,000) (76,000) Increase in accrued interest payable and other liabilities 221,000 594,000 368,000 Net Cash Provided by Operating Activities 2,605,000 2,172,000 2,137,000 Investing Activities: Proceeds from the maturities of investment securities 3,983,000 5,123,000 2,805,000 Proceeds from the sales of available-for-sale investment securities 25,833,000 1,989,000 17,779,000 Purchase of investment securities (47,623,000) (28,801,000) (5,216,000) Loans originated, net of collections (21,224,000) (21,865,000) (38,867,000) Purchase of bank premises and equipment (264,000) (336,000) (446,000) Net Cash Used by Investing Activities (39,295,000) (43,890,000) (23,945,000) Financing Activities: Net increase in deposits 31,161,000 51,738,000 21,290,000 Increase (decrease) in Federal Funds Purchased -- (3,600,000) 3,600,000 Proceeds from issuance of common stock 455,000 29,000 181,000 Cash paid for the repurchase of common stock (56,000) (37,000) (467,000) Cash paid in lieu of fractional shares -- (11,000) (4,000) Net Cash Provided by Financing Activities 31,560,000 48,119,000 24,600,000 Cash and Cash Equivalents: Increase (decrease) in cash and cash equivalents (5,130,000) 6,401,000 2,792,000 Cash and cash equivalents at beginning of year 21,810,000 15,409,000 12,617,000 Cash and Cash Equivalents at end of year $16,680,000 $21,810,000 $15,409,000 Additional Cash Flow Information: Interest Paid $6,911,000 $5,542,000 $3,559,000 Income Taxes Paid $2,228,000 $2,140,000 $825,000 <FN> The accompanying notes are an integral part of these consolidated statements. </FN> BWC FINANCIAL CORP NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: Summary of Significant Accounting Policies. The accounting and reporting policies of BWC Financial Corp. (the "Corporation") and its subsidiaries, Bank of Walnut Creek (the "Bank"), and BWC Real Estate, conform with generally accepted accounting principles and general practice within the banking industry. The following is a summary of the more significant accounting policies. Nature of Operations. BWC Financial Corp. operates four branches in Contra Costa County and three in northern Alameda County. The Corporation's primary source of revenue is providing loans to customers, who are predominately small and middle-market businesses and middle-income individuals. Basis of Presentation. The consolidated financial statements of the Corporation include the accounts of the Corporation, the Bank and BWC Real Estate. All significant inter-company balances and transactions have been eliminated in consolidation. BWC Real Estate, a subsidiary of the Corporation, was formed in 1994 to enter into a joint venture arrangement with a real estate brokerage firm, creating a company called BWC Mortgage Services. As BWC Real Estate owns 51% of this joint venture, the Corporation has consolidated BWC Mortgage Services for the years then ended December 31, 1998, 1997 and 1996. The real estate brokerage firm's joint venture interest is shown as minority interests in the financial statements. Previously issued financial statements for the years ended December 31, 1997 and 1996 accounted for BWC Mortgage Services using the equity method, as the subsidiary was not considered material. The restatement of prior years has no effect on net income. Investment Securities. The Corporation classifies its investments in debt and equity securities as "held-to-maturity," or "available-for-sale." Investments classified as held-to-maturity are reported at amortized cost; investments classified as available-for-sale are reported at fair value with unrealized gains and losses, net of related tax, if any, reported as a separate component of shareholders' equity. Amortization and accretion are included in interest income, while gains and losses on disposition are included in non-interest income and are determined using the specific identification method. The Corporation's policy of carrying investment securities as held-to- maturity is based upon its ability and management's intent to hold such securities to maturity. Loans are stated at the principal amount outstanding. Interest income is recognized using methods which approximate a level yield on principal amounts outstanding. The accrual of interest on loans is discontinued when the payment of principal or interest is considered to be in doubt, or when a loan becomes contractually past-due by 90 days or more with respect to principal or interest, except for loans that are well secured and in the process of collection. When a loan is placed on non-accrual status, any accrued but uncollected interest is reversed from current income. Loan origination fees are deferred and amortized as yield adjustments over the contractual lives of the underlying loans. Sales and Servicing of SBA Loans. The Corporation originates loans to customers under a Small Business Administration ("SBA") program that generally provides for SBA guarantees of 70% to 90% of each loan. The Corporation generally sells the guaranteed portion of each loan to a third party and retains the unguaranteed portion in its own portfolio. The Corporation may be required to refund a portion of the sales premium received, if the borrower defaults or the loan prepays within 90 days of the settlement date. As a result, the Corporation recognizes no gain or loss on these loan sales until the 90 day period elapses. On December 31, 1998 the Corporation was holding $142,000 in pending SBA fees. A gain is recognized on the sale of SBA loans through collection on the sale of a premium over the adjusted carrying value, through retention of an ongoing rate differential less a normal service fee (excess servicing fee) between the rate paid by the borrower to the Company and the rate paid by the Company to the purchaser, or both. To calculate the gain (loss) on sale, the Corporation's investment in an SBA loan is allocated among the retained portion of the loan and the sold portion of the loan, based on the relative fair value of each portion. The gain (loss) on the sold portion of the loan is recognized at the time of sale based on the difference between the sale proceeds and the allocated investment. As a result of the relative fair value allocation, the carrying value of the retained portion is discounted, with the discount accreted to interest income over the life of the loan. In the event of future prepayments, the unearned servicing fee is realized as additional fee income at the time of prepayment. Allowance for Credit Losses is based upon estimates of potential credit losses and is maintained at a level considered adequate to provide for losses that can be reasonably anticipated and is in accordance with Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan (SFAS 114). The allowance is increased by provisions charged to expense and reduced by net charge-offs. Management continually evaluates the economic climate and other conditions to determine the adequacy of the allowance. The allowance is based on estimates, and ultimate losses may vary from current estimates. As adjustments become necessary, they are reported in the periods in which they become known. Premises and Equipment consists of leasehold improvements, furniture and equipment and are stated at cost, less accumulated depreciation and amortization. Depreciation is computed on a straight-line basis over the estimated useful lives of furniture and equipment, primarily from five to fifteen years. Leasehold improvements are amortized over the terms of the leases or their estimated useful lives, whichever is shorter. Income Taxes. The Corporation files consolidated income tax returns which include both the parent company and its subsidiaries. The parent company reimburses the Bank for allocations of tax liabilities or benefits as determined by the parent company. Deferred income taxes are recorded for all significant income and expense items recognized in different periods for financial reporting and income tax purposes. Earnings Per Share (EPS). In accordance with SFAS No. 128, two EPS amounts are reported, Basic EPS, and Diluted EPS. Net Income Per Basic Share (Basic EPS) is calculated by dividing net income by weighted average shares outstanding. No dilution for any potentially dilutive securities is included. Weighted average shares and per share amounts reflect the 2 for 1 stock split on July 10, 1998 and the 10% stock dividend paid on February 3, 1998, March 31, 1997, and July 31, 1996. Net Income Per Diluted Share (Diluted EPS) is calculated by dividing net income by the weighted average shares outstanding during the period including the dilutive effect of stock options. Weighted average shares and per share amounts reflect the 2 for 1 stock split July 10, 1998 and the 10% stock dividend paid on February 3, 1998, March 31, 1997, and July 31, 1996. Letters of credit and commitments to extend credit are extended based upon evaluations of customer credit worthiness. The amount of collateral obtained is based upon these evaluations. Collateral held varies but may include accounts receivable, inventory, property, plant and equipment, and income-producing commercial properties. Standby letters of credit and commitments to extend credit generally have fixed expiration dates or other termination clauses. Because many of the standby letters of credit and commitments to extend credit are expected to expire without being drawn upon, total guarantee and commitment amounts do not necessarily represent future cash requirements. Significant Group Concentrations of Credit Risk. The Bank accepts deposits and grants credit primarily within its local service area, the counties of Contra Costa and Alameda, California. The Bank has a diversified loan portfolio and grants consumer, commercial and construction real estate loans, and is not dependent on any industry or group of customers. Although the Bank has a diversified loan portfolio, a substantial portion of its loans are real estate related. Statement of Cash Flows. For purposes of reporting cash flows, cash and cash equivalents include cash and due from banks and federal funds sold. Use of Estimates in the Preparation of Financial Statements. The preparation of financial statements in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Accounting for Stock-based Compensation. The Corporation uses the intrinsic value method to account for its stock option plans (in accordance with the provisions of Accounting Principles Board Opinion No. 25). Under this method, compensation expense is recognized for awards of options to purchase shares of common stock to employees under compensatory plans only if the fair market value of the stock at the option grant date (or other measurement date, if later) is greater than the amount the employee must pay to acquire the stock. Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123) permits companies to continue using the intrinsic value method or to adopt a fair value based method to account for stock option plans. The fair value based method results in recognizing as expense over the vesting period the fair value of all stock-based awards on the date of grant. The Corporation has elected to continue to use the intrinsic value method and the pro forma disclosures required by SFAS 123 are included in Note 9. NOTE 2: INVESTMENT SECURITIES An analysis of the investment security portfolio at December 31 follows: 1998 Gross Gross Amortized Unrealized Unrealized Fair Available-for-sale Cost Gains Loss Value U.S. Treasury Securities $7,565,000 $97,000 -- $7,662,000 Securities of U.S. Government Agencies 22,175,000 190,000 -- 22,365,000 Taxable Securities of State and Political Subdivisions 11,554,000 279,000 -- 11,833,000 Corporate Debt Securities 3,820,000 -- 25,000 3,795,000 Total 45,114,000 566,000 25,000 45,655,000 Held-to-maturity Obligations of State and Political Subdivisions 13,592,000 205,000 -- 13,797,000 Total Investment Securities $58,706,000 $771,000 25,000 $59,452,000 1997 Gross Gross Amortized Unrealized Unrealized Fair Available-for-sale Cost Gains Loss Value U.S. Treasury Securities $10,053,000 $66,000 -- $10,119,000 Securities of U.S. Government Agencies 16,478,000 74,000 -- 16,552,000 Taxable Securities of State and Political Subdivisions 6,320,000 71,000 -- 6,391,000 Total 32,851,000 211,000 -- 33,062,000 Held-to-maturity Obligations of State and Political Subdivisions 7,894,000 56,000 -- 7,950,000 Total Investment Securities $40,745,000 $267,000 -- $41,012,000 <FN> In 1998 and 1997, the Bank received proceeds from sale of investment securities of $25,833,000 and $1,989,000 respectively, and gains included in other noninterest income totaled $216,000 and $11,000 respectively. </FN> The maturities of the investment security portfolio at December 31, 1998 follow: Held-to-maturity Amortized Fair Cost Value Within one year $2,356,000 $2,371,000 After one through five years 5,374,000 5,463,000 Over five years 5,862,000 5,963,000 Total $13,592,000 $13,797,000 Available-for-sale Amortized Fair Cost Value Within one year $5,258,000 $5,307,000 After one through five years 26,686,000 26,716,000 Over five years 13,170,000 13,632,000 Total $45,114,000 $45,655,000 <FN> At December 31, 1998 and 1997, securities with an approximate book value of $7,864,000 and $4,862,000 respectively, were pledged to secure public deposits. </FN> NOTE 3: LOANS The majority of the Bank's loans are to customers in Contra Costa and Alameda Counties and surrounding areas. Depending upon the type of loan, the Bank generally obtains a secured interest in the general assets of the borrower and/or in any assets being financed. Outstanding loans by type were: December 31 1998 1997 Real Estate Construction $69,054,000 $53,894,000 Real Estate Mortgages 21,533,000 23,648,000 Commercial 64,261,000 56,403,000 Installment 32,129,000 29,993,000 TOTAL 186,977,000 163,938,000 Less: Allowance for Credit Losses (3,919,000) (2,936,000) NET LOANS $183,058,000 $161,002,000 The following table provides further information on past due and nonaccrual loans. December 31 1998 1997 Loans Past Due 90 Days or More, still accruing interest $0 $16,000 Nonaccrual Loans $2,176,000 $232,000 TOTAL $2,176,000 $248,000 As of December 31, 1998, the Corporation's recorded investment in impaired loans was $2,176,000. Due to the loans underlying collateral value, no valuation allowance was required. For the years ending December 31, 1997 and 1996, the Corporation's recorded investment in impaired loans and the related valuation allowance calculated under SFAS No. 114 was not material. As of December 31, 1998 and 1997, no loans were outstanding that had been restructured. No interest earned on nonaccrual loans that was recorded in income remains uncollected. Interest foregone on nonaccrual loans was approximately $89,000 in 1998, $24,000 in 1997, and $9,000 in 1996. NOTE 4: ALLOWANCES FOR CREDIT LOSSES For the Year Ended December 31 1998 1997 1996 Total loans outstanding at end of period, before deducting allowance for credit losses $186,977,000 $163,938,000 $140,771,000 Average total loans outstanding during period $166,698,000 $149,043,000 $112,356,000 Analysis of the allowance for credit losses: Beginning Balance $2,936,000 $1,893,000 $1,528,000 Charge-offs: Real Estate Construction -- -- -- Real Estate Mortgages -- -- -- Commercial 17,000 139,000 263,000 Installment 96,000 54,000 58,000 TOTAL CHARGE-OFFS 113,000 193,000 321,000 Recoveries: Real Estate Mortgages 40,000 3,000 -- Commercial 215,000 101,000 29,000 Installment 16,000 7,000 7,000 TOTAL RECOVERIES 271,000 111,000 36,000 NET CHARGE-OFFS (RECOVERIES) (158,000) 82,000 285,000 Provisions charged to operating expense 825,000 1,125,000 650,000 Ending Balance $3,919,000 $2,936,000 $1,893,000 Ratio of net charge-offs (recoveries) to average total loans (0.09)% 0.06% 0.25% Ratio of allowance for credit losses to total loans at end of period 2.10% 1.79% 1.34% NOTE 5: PREMISES AND EQUIPMENT A summary of premises and equipment follows: December 31, 1998 1997 Leasehold Improvements $1,141,000 $1,129,000 Furniture and Equipment 2,834,000 2,593,000 3,975,000 3,722,000 Accumulated Depreciation and Amortization (2,672,000) (2,267,000) Premises and Equipment, Net $1,303,000 $1,455,000 The amount of depreciation and amortization included in occupancy and furniture and equipment expense was $416,000 in 1998, $403,000 in 1997, and $386,000 in 1996. NOTE 6: COMPREHENSIVE INCOME The Bank has adopted Statement of Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (SFAS 130), as of January 1, 1998. This statement established standards for the reporting and display of comprehensive income and its components in the financial statements. For the Bank, comprehensive income includes net income reported on the statements of income and changes in the fair value of its available-for-sale investments reported as a component of shareholders' equity. The components of other comprehensive income for the years ended December 31, 1998, 1997 and 1996, are as follows: 1998 1997 1996 Unrealized gain (loss) arising during the period, net of tax. $330,000 $139,000 ($108,000) Reclassification adjustment for net realized gains on securities available for sale included in net income during the year, net of tax. 134,000 7,000 13,000 Net unrealized gain (loss) included in other comprehensive income. $ 196,000 $132,000 ($121,000) NOTE 7: FAIR VALUE OF FINANCIAL INSTRUMENTS The following table presents the carrying amounts and fair values of the Corporation's financial instruments at December 31, 1998 and 1997. SFAS No. 107, "Disclosures about Fair Value of Financial Instruments", defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than if a forced or liquidation sale. 1998 Carrying Fair Amount Value Cash and cash equivalents $ 16,680,000 $ 16,680,000 Investment securities 59,247,000 59,452,000 Loans (net) 183,058,000 185,594,000 Deposit liabilities 238,140,000 240,571,000 Other liabilities 2,416,000 2,416,000 1997 Carrying Fair Amount Value Cash and cash equivalents $ 21,810,000 $ 21,810,000 Investment securities 40,956,000 41,012,000 Loans (net) 161,002,000 164,830,000 Deposit liabilities 206,979,000 207,677,000 Other liabilities 2,195,000 2,195,000 The carrying amounts in the table are included in the consolidated balance sheets under the indicated captions. The following notes summarize the major methods and assumptions used in estimating the fair values of financial instruments. Short-term financial instruments are valued at their carrying amounts included in the statement of financial position, which are reasonable estimates of fair value due to the relatively short period to maturity of the instruments. This approach applies to cash and cash equivalents, accrued interest receivable and payable. Loans are valued on the basis of estimated future receipts of principal and interest, discounted at various rates. Loan prepayments are assumed to occur at the same rate as in previous periods when interest rates were at levels similar to current levels. Future cash flows for homogeneous categories of consumer loans, are estimated on a portfolio basis and discounted at current rates offered for similar loan terms to new borrowers with similar credit profiles. The fair value of nonaccrual loans also is estimated on a present value basis, using higher discount rates appropriate to the higher risk involved. Investment securities are valued at quoted market prices if available. For unquoted securities, the reported fair value is estimated on the basis of financial and other information. Fair value of demand deposits and deposits with no defined maturity is taken to be the amount payable on demand at the reporting date. The fair value of fixed-maturity deposits is estimated using rates currently offered for deposits of similar remaining maturities. The intangible value of long-term relationships with depositors is not taken into account in estimating the fair values disclosed. NOTE 8: INCOME TAXES The provisions for income taxes in 1998, 1997, and 1996 consist of the following: 1998 1997 1996 CURRENT Federal $2,286,000 $1,674,000 $820,000 State 936,000 630,000 365,000 TOTAL CURRENT 3,222,000 2,304,000 1,185,000 DEFERRED Federal (383,000) (431,000) (176,000) State (160,000) (144,000) (36,000) TOTAL DEFERRED (543,000) (575,000) (212,000) TOTAL $2,679,000 $1,729,000 $973,000 The components of the net deferred tax assets of the Bank as of December 31, 1998 and 1997 were as follows: Deferred Tax Assets: 1998 1997 Allowance for credit losses $1,551,000 $1,197,000 Employee benefits and other 202,000 126,000 State taxes 152,000 67,000 Total deferred tax assets 1,905,000 1,390,000 Deferred Tax Liabilities: Depreciation and other -- (18,000) Accretion and other -- (10,000) SFAS 115 deferred tax liability (206,000) (54,000) Total deferred tax liabilities (206,000) (82,000) Net deferred tax asset $1,699,000 $1,308,000 The provisions for income taxes differ from the amounts computed by applying the statutory Federal income tax rate to income before taxes. The reasons for these differences are as follows: 1998 1997 1996 Provision based on the statutory Federal rate of 34% $2,348,000 $1,582,000 $986,000 Increases (reduction) in income taxes resulting from: State franchise taxes, net of Federal income tax benefit 500,000 329,000 216,000 Non-taxable interest income (188,000) (130,000) (178,000) Other 19,000 (52,000) (51,000) TOTAL $2,679,000 $1,729,000 $973,000 Note 9: STOCK OPTIONS In 1990, the Board of Directors of the Corporation adopted the 1990 Stock Option Plan covering an aggregate 708,624 shares (adjusted for subsequent stock dividends and the stock split) of the Corporation's common stock. Under the 1990 Stock Option Plan, options to purchase shares of the Corporation's common stock may be granted to certain key employees. The options may be incentive stock options or nonqualified stock options. If incentive options are granted, the exercise price of the options will be the fair market value of the shares on the date the option is granted. The exercise price of nonqualified stock options to be granted can be below the fair market value of the shares at the grant date. To date all options granted have been at the fair market value of the shares at the grant date, and are nontransferable and are exercisable in installments. As of December 31, 1998, 100,837 shares were available for future grant. The options, with the exception of one grant, are fully vested after five years and expire after ten years. The other grant is fully vested after ten years. A summary of the status of the Corporation's stock option plan at December 31, 1998, 1997 and 1996, which presents changes during the years then ended is presented in the table below. Figures have been adjusted to reflect the 2 for 1 stock split issued July 10, 1998 and to the 10% stock dividends given in February 1998, March 1997 and July 1996. Weighted Weighted Weighted average average average 1998 exercise 1997 exercise 1996 exercise Shares price Shares price Shares price Outstanding at beginning of year 532,740 $ 3.48 526,098 $ 3.33 512,788 $ 3.22 Granted 64,641 $15.59 17,050 $10.63 13,310 $ 7.47 Exercised 16,841 $ 3.65 10,408 $ 3.10 -- $ -- Outstanding at end of year 580,540 $ 4.87 532,740 $ 3.48 526,098 $ 3.33 Exercisable at end of year 510,009 $ 3.70 491,144 $ 3.34 490,486 $ 3.25 Weighted average fair value of options granted during the year $ 9.32 $ 4.83 $ 3.96 Had the Corporation used the fair value method prescribed by SFAS 123 (See Note 1), the Corporation's net income and earnings per share would have been reduced to the pro forma amounts indicated below: 1998 1997 1996 Net Income: As reported $4,228,000 $2,925,000 $1,928,000 Pro forma 4,110,000 2,901,000 1,920,000 Basic Earnings per share: As reported $ 1.70 $ 1.18 $ 0.71 Pro forma 1.65 1.17 0.70 Diluted Earnings per share: As reported $ 1.44 $ 1.02 $ 0.64 Pro forma 1.40 1.02 0.63 The fair value of each option grant in 1998, 1997 and 1996, is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions used for grants in 1998, 1997 and 1996: risk free rate of 7.00% for 1998 and 1997 and 6.75% for 1996, no expected dividend yield, expected life of 8 years and expected volatility of 24.26% in 1998, 17.84% in 1997 and 16.41% in 1996. Because SFAS 123 method of accounting has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation cost, indicated above, may not be representative of that to be expected in future years. The following table summarizes information about stock options outstanding at December 31, 1998. Options Outstanding: Options Weighted Weighted Exercisable: Weighted Range of Number Average Average Number Average exercise Outstanding Contractual Exercise Exercisable Exercise prices at 12/31/98 Life Remaining Price at 12/31/98 Price $ 2.79 to $ 9.92 519,540 2.76 $ 3.49 495,609 $ 3.32 $11.02 to $19.13 61,000 8.38 $17.66 14,400 $16.65 NOTE 10: COMMITMENTS AND CONTINGENCIES As of December 31, 1998 the approximate future minimum net rental payments under non-cancellable operating leases for premises were as follows: Year Amount 1999 $677,000 2000 583,000 2001 205,000 2002 154,000 2003 154,000 Thereafter 1,046,000 Total $2,819,000 Rental expense for premises under operating leases included in occupancy expense was $554,000, $527,000, and $507,000, in 1998, 1997, and 1996, respectively. Minimum rentals may be adjusted for increases in the lessors' operating costs and/or increases in the Consumer Price Index. At December 31, 1998, the Bank had outstanding approximately $113,968,000 in undisbursed loan commitments and $3,673,000 in standby letters of credit, which are not reflected in the accompanying consolidated balance sheets. Management does not anticipate any material losses to result from these transactions. The fair value of commitments to extend credit is estimated by using the fees currently charged to others to enter into similar agreements taking into account the terms of the agreements and the present creditworthiness of the counterparties. The fair value of commitments at December 31, 1998 was immaterial. NOTE 11: DEFINED CONTRIBUTION PLAN Substantially all eligible, salaried employees of the Corporation are covered by a defined contribution plan. Employees may, up to prescribed limits, contribute to the plan. Portions of such contributions are matched by the Corporation. The Corporation also may elect to make a discretionary contribution to the plan based on the Corporation's earnings. The expense for this plan, for both matching and discretionary contributions, was $244,000, $162,000, and $144,000 in 1998, 1997, and 1996, respectively. Amounts vary from year to year based on such factors as employees entering and leaving the plan, profits earned by the Corporation, and variances of estimates from the final results. NOTE 12: OTHER NONINTEREST EXPENSE Other noninterest expense is comprised of the following: 1998 1997 1996 Data Processing $327,000 $336,000 $293,000 Business Development & Education 304,000 239,000 235,000 Telephone and Postage 291,000 265,000 241,000 Professional Fees 318,000 244,000 193,000 Supplies 240,000 211,000 192,000 Marketing 208,000 151,000 163,000 Regulatory Fees 47,000 47,000 21,000 Other 1,226,000 908,000 840,000 TOTAL $2,961,000 $2,401,000 $2,178,000 NOTE 13: RESTRICTIONS ON SUBSIDIARY TRANSACTIONS The Bank is subject to legal limitations on the amount of dividends that can be paid to the Corporation without prior approval from regulatory authorities. The limitations for a given year equal the lesser of the Bank's net profits (as defined in the regulations) for the current year, combined with the retained net profits for the preceding two years or the Bank's retained earnings. Under these restrictions, $8,531,000 of the Bank's retained earnings were available for dividends at December 31, 1998. The Bank is subject to certain restrictions under the Federal Reserve Act, including restrictions on the extension of credit to affiliates. In particular, the Corporation is prohibited from borrowing from the Bank, unless the loans are secured by specified types of collateral. Such secured loans and other advances from the Bank are limited to 10% of the Bank's shareholders equity. Under these provisions, secured loans and advances to the Corporation were limited to $2,265,000 as of December 31, 1998. There were no such extensions of credit by the Bank in 1998 or 1997. NOTE 14: PARENT COMPANY ONLY CONDENSED FINANCIAL INFORMATION A summary of the financial statements of BWC Financial Corp. (parent company only) follows: December 31 SUMMARY BALANCE SHEETS 1998 1997 ASSETS Cash on Deposit with the Bank $1,007,000 $660,000 Investment in the Bank 22,656,000 18,461,000 Investment in BWC Real Estate 680,000 333,000 TOTAL ASSETS $24,343,000 $19,454,000 LIABILITIES SHAREHOLDERS' EQUITY Common Stock $19,002,000 $18,603,000 Retained Earnings 5,341,000 851,000 TOTAL SHAREHOLDERS' EQUITY $24,343,000 $19,454,000 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $24,343,000 $19,454,000 SUMMARY STATEMENTS OF INCOME FOR THE YEAR ENDED DECEMBER 31, 1998 1997 1996 Expenses - General and Administrative $74,000 $13,000 $13,000 Loss before income taxes and equity in undistributed net income of Subsidiaries (74,000) (13,000) (13,000) Income tax benefit 28,000 5,000 8,000 Equity in undistributed net income of BWC Real Estate 340,000 162,000 107,000 Equity in undistributed net income of the Bank 3,934,000 2,771,000 1,826,000 NET INCOME $4,228,000 $2,925,000 $1,928,000 SUMMARY STATEMENTS OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, OPERATING ACTIVITIES: 1998 1997 1996 Net Income $4,228,000 $2,925,000 $1,928,000 Adjustments to reconcile net income to net cash used by operating activities: Equity in undistributed net income of Subsidiaries (4,274,000) (2,933,000) (1,933,000) Taxes Payable -- -- (21,000) NET CASH USED BY OPERATING ACTIVITIES (46,000) (8,000) (26,000) FINANCING ACTIVITIES: Proceeds from issuance of common stock 455,000 29,000 181,000 Cash paid in lieu of fractional shares 0 (12,000) (4,000) Shares repurchased by the Corporation (56,000) (37,000) (467,000) Investment in BWC Real Estate -- -- (10,000) NET CASH PROVIDED (USED) BY FINANCING ACTIVITIES 399,000 (20,000) (300,000) Increase (Decrease) in Cash 353,000 (28,000) (326,000) CASH ON DEPOSIT WITH THE BANK: Beginning of year 653,000 681,000 1,007,000 End of year $1,006,000 $653,000 $681,000 NOTE 15: Regulatory Matters The Corporation and the Bank are subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory, and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Corporation and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Corporation and the Bank must meet specific capital guidelines that involve quantitative measures of the Corporation and the Bank's assets, liabilities and certain off-balance- sheet items as calculated under regulatory accounting practices. The Corporation and the Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 1998, that the Corporation and the Bank meet all capital adequacy requirements to which they are subject. As of December 31, 1998, the most recent notification from FDIC categorized the Corporation and the Bank as "Well Capitalized" under the regulatory framework for prompt corrective action. To be categorized as "Well Capitalized" the Corporation and the Bank must maintain minimum total risk- based, Tier I risk-based, Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the institution's category. NOTE 15 (Continued) The Corporation's and Bank's actual capital amounts and ratios are presented in the following table: Minimum Capital Minimum Actual Adequacy for Well Amount Ratio Requirements Capitalized As of December 31, 1998 Total Capital (to Risk Weighted Assets) Consolidated: $26,049,000 12.17% $17,121,000 > 8.0 $21,401,000 >10.0 Bank of Walnut Creek: $25,042,000 11.70% $17,121,000 > 8.0 $21,401,000 >10.0 Tier 1 Capital (to Risk Weighted Assets) Consolidated: $23,327,000 10.90% $8,560,000 > 4.0 $12,840,000 > 6.0 Bank of Walnut Creek: $22,320,000 10.43% $8,560,000 > 4.0 $12,840,000 > 6.0 Tier 1 Capital (to Average Assets) Consolidated: $23,327,000 9.40% $9,925,000 > 4.0 $12,406,000 > 5.0 Bank of Walnut Creek: $22,320,000 9.00% $9,925,000 > 4.0 $12,406,000 > 5.0 As of December 31, 1997 Total Capital (to Risk Weighted Assets) Consolidated: $21,539,000 12.15% $14,178,000 > 8.0 $17,723,000 >10.0 Bank of Walnut Creek: $20,546,000 11.59% $14,178,000 > 8.0 $17,723,000 >10.0 Tier 1 Capital (to Risk Weighted Assets) Consolidated: $19,315,000 10.90% $7,089,000 > 4.0 $10,634,000 > 6.0 Bank of Walnut Creek: $18,322,000 10.34% $7,089,000 > 4.0 $10,634,000 > 6.0 Tier 1 Capital (to Average Assets) Consolidated: $19,315,000 9.65% $8,016,000 > 4.0 $10,021,000 > 5.0 Bank of Walnut Creek: $18,322,000 9.15% $8,006,000 > 4.0 $10,008,000 > 5.0 Note 16: FASB 131 DISCLOSURE The Corporation adopted Statement of Financial Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and Related Information" (SFAS 131) as of January 1, 1998. This statement establishes standards for the reporting and display of information about operating segments in financial statements and related disclosures. The Corporation is principally engaged in community banking activities through its seven Bank branches. In addition to its community banking activities, the Corporation provides mortgage brokerage services through its joint venture, BWC Mortgage Services. These activities are monitored and reported by Corporation management as a separate operating segment. As permitted under the Statement, the separate banking offices have been aggregated into a single reportable segment, Community Banking. The other operating segments do not meet the prescribed aggregation or materiality criteria and therefore are reported as "All other" in the following table. The Corporation's community banking segment provides loans, leases and lines of credit to local businesses and individuals. This segment also derives revenue by investing funds, that are not loaned to others in the form of loans, leases or lines of credits, into investment securities. The business purpose of BWC Mortgage Services is the origination and placement of long- term financing for real estate mortgages. Summarized financial information for the years ended December 31, 1998, 1997 and 1996 concerning the Corporation's reportable segments is shown in the following table. Community Mortgage 1998 Banking Services All Other Adjustments Total Total Interest Income $21,862,000 $21,862,000 Commissions Received $3,744,000 3,744,000 Total Interest Expense 6,774,000 6,774,000 Salaries & Benefits 5,344,000 5,344,000 Commissions Paid 2,199,000 2,199,000 Segment Profit before Tax 6,405,000 1,097,000 ($595,000) 6,907,000 Total Assets (at December 31) $264,758,000 $518,000 $1,007,000 ($1,384,000) $264,899,000 Community Mortgage 1997 Banking Services All Other Adjustments Total Total Interest Income $18,316,000 $18,316,000 Commissions Received $2,077,000 2,077,000 Total Interest Expense 5,770,000 5,770,000 Salaries & Benefits 4,737,000 4,737,000 Commissions Paid 1,201,000 1,201,000 Segment Profit before Tax 4,400,000 514,000 ($260,000) 4,654,000 Total Assets (at December 31) $228,590,000 $150,000 $660,000 ($778,000) $228,622,000 Community Mortgage 1996 Banking Services All Other Adjustments Total Total Interest Income $13,238,000 $13,238,000 Commissions Received $1,367,000 1,367,000 Total Interest Expense 3,764,000 3,764,000 Salaries & Benefits 3,829,000 3,829,000 Commissions Paid 785,000 785,000 Segment Profit before Tax 2,744,000 320,000 ($163,000) $2,901,000 Total Assets (at December 31) $177,202,000 $111,000 $682,000 ($739,000) $177,256,000 NOTE 17: SFAS 133 In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, (SFAS 133) Accounting for Derivative Instruments and Hedging Activities. The Statement establishes accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. The Statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. SFAS 133 is effective for fiscal years beginning after June 15, 1999. A company may also implement the Statement as of the beginning of any fiscal quarter after issuance (that is, fiscal quarters beginning June 16, 1998 and thereafter). SFAS 133 cannot be applied retroactively. SFAS 133 must be applied to (a) derivative instruments and (b) certain derivative instruments embedded in hybrid contracts that were issued, acquired, or substantively modified after December 31, 1997 (and, at the Corporation's election, before January 1, 1998). The Corporation has no derivative or hedged instruments and therefore the implementation of this statement is not expected to have a material impact on the Corporation's financial position or results of operations. REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Shareholders and Board of Directors of BWC Financial Corp.: We have audited the accompanying consolidated balance sheets of BWC Financial Corp. (a California corporation) and Subsidiaries (the Corporation) as of December 31, 1998 and 1997, and the related consolidated statements of income, changes in shareholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These consolidated financial statements are the responsibility of the Corporation's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of BWC Financial Corp. and Subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles. ARTHUR ANDERSEN, LLP San Francisco, California February 22, 1999 <FN> MANAGEMENT'S DISCUSSION AND ANALYSIS OF OPERATIONS The following is a summary of selected consolidated financial data for the five years ended December 31, 1998. The summary is followed by management's discussion and analysis of the significant changes in income and expense presented therein. This information should be read in conjunction with the consolidated financial statements and notes related thereto appearing elsewhere in this annual report. </FN> 1998 1997 1996 1995 1994 SUMMARY OF EARNINGS Interest Income $21,862,000 $18,316,000 $13,238,000 $11,491,000 $9,673,000 Interest Expense 6,774,000 5,770,000 3,764,000 3,410,000 2,547,000 Net Interest Income 15,088,000 12,546,000 9,474,000 8,081,000 7,126,000 Provision for Credit Losses 825,000 1,125,000 650,000 330,000 255,000 Net Interest Income after Provision for Credit Losses 14,263,000 11,421,000 8,824,000 7,751,000 6,871,000 Noninterest Income 5,955,000 3,729,000 2,732,000 1,136,000 651,000 Noninterest Expense 12,762,000 10,244,000 8,498,000 6,444,000 5,867,000 Minority Interest 549,000 252,000 157,000 -- -- Income Before Income Taxes 6,907,000 4,654,000 2,901,000 2,443,000 1,655,000 Provision for Income Taxes 2,679,000 1,729,000 973,000 823,000 481,000 NET INCOME 4,228,000 2,925,000 1,928,000 1,620,000 1,174,000 Diluted Earnings Per Share (1) $1.44 $1.03 $0.64 $0.61 $0.45 Average Diluted Shares (1) 2,926,428 2,842,772 3,034,922 2,636,636 2,591,158 Book Value Per Diluted Share (1) $8.32 $6.84 $5.41 $5.65 $4.88 SUMMARY BALANCE SHEETS AT DECEMBER 31 Cash and Due from Banks $14,345,000 $17,412,000 $15,212,000 $11,377,000 $8,552,000 Federal Funds Sold 2,300,000 4,350,000 -- 1,230,000 3,300,000 Other short Term Investments 35,000 48,000 26,000 10,000 3,018,000 Investment Securities 59,247,000 40,956,000 19,125,000 34,471,000 28,754,000 Loans, Net 183,058,000 161,002,000 138,878,000 99,776,000 86,411,000 Other Assets 5,914,000 4,854,000 4,015,000 3,733,000 3,109,000 TOTAL ASSETS $264,899,000 $228,622,000 $177,256,000 $150,597,000 $133,144,000 Noninterest-bearing Deposits $69,783,000 $59,354,000 $41,519,000 $36,854,000 $27,340,000 Interest-bearing Deposits 168,357,000 147,625,000 114,125,000 97,747,000 92,632,000 Federal Funds Purchased -- -- 3,600,000 -- -- Other Liabilities 2,416,000 2,195,000 1,602,000 1,103,000 529,000 Shareholders' Equity 24,343,000 19,448,000 16,410,000 14,893,000 12,643,000 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $264,899,000 $228,622,000 $177,256,000 $150,597,000 $133,144,000 <FN> (1) All share and per-share amounts give effect to the 2 for 1 stock split of July, 1998 and to the 10% stock dividends given in February 1998, March 1997, July 1996, and June 1995. </FN> <FN> INTEREST RATE SENSITIVITY (in thousands except share and per share data) Proper management of the rate sensitivity and maturities of assets and liabilities is required to provide an optimum and stable net interest margin. Interest rate sensitivity spread management is an important tool for achieving this objective and for developing strategies and means to improve profitability. The schedules shown below reflect the interest rate sensitivity position of the Corporation as of December 31, 1998. Management believes that the sensitivity ratios reflected in these schedules fall within acceptable ranges, and represent no undue interest rate risk to the future earnings prospects of the Corporation. </FN> 3 3-6 12 1-5 Over 5 Repricing within: months months months years years Totals ASSETS: Federal funds sold & Short Term Inv. $2,335 $- $- $- $- $2,335 Investment securities 500 2,315 4,847 32,091 19,699 59,452 Construction & real estate loans 78,951 6,190 3,778 1,280 388 90,587 Commercial loans 54,881 3,929 4,934 517 - 64,261 Consumer Loans 27,555 391 722 1,780 2 30,450 Leases 165 193 379 942 - 1,679 Interest-bearing assets 164,387 13,018 14,660 36,610 20,089 248,764 Savings and Now accounts $37,139 $- $- $- $- $37,139 Money market accounts 64,687 - - - - 64,687 Time deposits <$100,000 10,373 11,503 10,517 1,900 - 34,293 Time deposits >$100,000 16,276 8,678 6,136 1,148 - 32,238 Interest-bearing liabilities 128,475 20,181 16,653 3,048 - 168,357 Rate sensitive gap $35,912 ($7,163) ($1,993) $33,562 $20,089 $80,407 Cumulatire rate sensitive gap $35,912 $28,749 $26,756 $60,318 $80,407 Cumulative rate sensitive ratio 1.28 1.19 1.16 1.36 1.48