================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] Quarterly Report PURSUANT TO Section 13 or 15(d) of the SECURITIES Exchange Act of 1934 For the quarterly period ended June 30, 2002 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______ to ______ Commission file number: 0-19231 REDWOOD EMPIRE BANCORP (Exact name of registrant as specified in its charter) California 68-0166366 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 111 Santa Rosa Avenue, Santa Rosa, California 95404-4905 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (707) 573-4800 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 _ At August 7, 2002, there were 3,489,840 shares of the Registrant's common stock outstanding. This page is page 1 of 40 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Index Page PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Statements of Operations Three and Six Months Ended June 30, 2002 and 2001.............................3 Consolidated Balance Sheets June 30, 2002 and December 31, 2001...........................................5 Consolidated Statements of Cash Flows Six Months Ended June 30, 2002 and 2001.......................................6 Notes to Consolidated Financial Statements....................................8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.............................13 Item 3. Quantitative and Qualitative Disclosures About Market Risk............................................................35 PART II. OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds......................................38 Item 4. Submission of Matters to a Vote of Security Holders............................38 Item 6. Exhibits and Reports on Form 8-K...............................................38 SIGNATURES.....................................................................................40 This page is page 2 of 40 pages. PART I. FINANCIAL INFORMATION Item 1. Financial Statements REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Operations (dollars in thousands except per share data) (unaudited) Three Months Ended Six Months Ended June 30, June 30, 2002 2001 2002 2001 -------------------------------------------------------- Interest income: Interest and fees on loans $6,486 $6,967 $12,703 $14,356 Interest on investment securities 1,128 1,212 2,216 2,599 Interest on federal funds sold 120 263 224 540 -------------------------------------------------------- Total interest income 7,734 8,442 15,143 17,495 Interest expense: Interest on deposits 2,132 3,333 4,294 6,933 Interest on other borrowings 279 283 537 435 -------------------------------------------------------- Total interest expense 2,411 3,616 4,831 7,368 -------------------------------------------------------- Net interest income 5,323 4,826 10,312 10,127 Provision for loan losses --- --- --- --- -------------------------------------------------------- Net interest income after provision for loan losses 5,323 4,826 10,312 10,127 Noninterest income: Service charges on deposit accounts 308 266 622 535 Merchant draft processing, net 1,197 1,019 2,376 1,832 Loan servicing income 81 80 135 157 Net realized gains on investment securities available for sale --- --- 35 --- Other income 207 187 443 393 -------------------------------------------------------- Total noninterest income 1,793 1,552 3,611 2,917 Noninterest expense: Salaries and employee benefits 2,302 1,989 4,348 4,221 Occupancy and equipment expense 533 503 1,057 992 Other 1,069 940 2,237 1,869 -------------------------------------------------------- Total noninterest expense 3,904 3,432 7,642 7,082 -------------------------------------------------------- Income before income taxes 3,212 2,946 6,281 5,962 Provision for income taxes 1,187 1,178 2,309 2,407 -------------------------------------------------------- Net income $2,025 $1,768 $3,972 $3,555 ======================================================== Total comprehensive income $2,697 $1,754 $4,409 $4,009 ======================================================== (Continued) This page is page 3 of 40 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Operations (dollars in thousands except per share data) (unaudited) (Continued) Three Months Ended Six Months Ended June 30, June 30, 2002 2001 2002 2001 -------------------------------------------------------------- Basic earnings per common share: Net income $.58 $.49 $1.14 $.92 Weighted average shares - basic 3,491,000 3,621,000 3,495,000 3,850,500 Diluted earnings per common share: Net income $.56 $.47 $1.10 $.90 Weighted average shares - diluted 3,617,000 3,733,500 3,624,000 3,967,500 See Notes to Consolidated Financial Statements. (Concluded) This page is page 4 of 40 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Balance Sheets (dollars in thousands) June 30, December 31, 2002 2001 ----------------- ----------------- (unaudited) Assets: Cash and due from banks $22,714 $19,596 Federal funds sold 34,863 4,653 ----------------- ----------------- Cash and cash equivalents 57,577 24,249 Investment securities: Held to maturity (fair value of $16,797 and $17,635) 16,326 17,402 Available for sale, at fair value (amortized cost of $57,484 and $46,433) 59,227 47,573 ----------------- ---------------- Total investment securities 75,553 64,975 Mortgage loans held for sale 313 --- Loans: Residential real estate mortgage 93,698 101,175 Commercial real estate mortgage 140,020 121,456 Commercial 69,464 70,438 Real estate construction 43,152 46,501 Installment and other 12,223 12,567 Less net deferred loan fees (695) (488) ----------------- ----------------- Total portfolio loans 357,862 351,649 Less allowance for loan losses (7,586) (7,580) ----------------- ----------------- Net loans 350,276 344,069 Premises and equipment, net 2,960 2,636 Mortgage servicing rights, net 4 4 Cash surrender value of life insurance 3,530 3,443 Other assets and interest receivable 10,346 9,366 ----------------- ----------------- Total assets $500,559 $448,742 ================= ================= Liabilities and Shareholders' equity: Deposits: Noninterest bearing demand deposits $106,578 $86,969 Interest-bearing transaction accounts 120,020 121,457 Time deposits one hundred thousand and over 91,816 112,638 Other time deposits 126,737 76,348 ----------------- ----------------- Total deposits 445,151 397,412 Short-term borrowings 5,823 3,870 Trust preferred securities 10,000 10,000 Other liabilities and interest payable 11,038 10,773 ----------------- ----------------- Total liabilities 472,012 422,055 Shareholders' equity: Preferred stock, no par value; authorized 2,000,000 shares; none issued and outstanding --- --- Common stock, no par value; authorized 10,000,000 shares; issued and outstanding: 3,494,840 and 3,530,135 shares 12,193 12,373 Retained earnings 15,256 13,653 Accumulated other comprehensive income, net of tax 1,098 661 ----------------- ----------------- Total shareholders' equity 28,547 26,687 ----------------- ----------------- Total liabilities and shareholders' equity $500,559 $448,742 ================= ================= See Notes to Consolidated Financial Statements. This page is page 5 of 40 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) (unaudited) Six Months Ended June 30, 2002 2001 --------------------------------- Cash flows from operating activities: Net income $3,972 $3,555 Adjustments to reconcile net income to net cash from operating activities: Depreciation and amortization, net 45 33 Loans originated for sale (608) --- Proceeds from sale of loans held for sale 300 --- Net realized gains on securities available for sale (35) --- Net realized gains on sale of loans held for sale (5) --- Change in other assets and interest receivable (1,240) (467) Change in other liabilities and interest payable 265 395 Other, net --- 30 --------------------------------- Total adjustments (1,278) (9) --------------------------------- Net cash from operating activities 2,694 3,546 Cash flows from investing activities: Net change in loans (5,952) (10,134) Purchases of investment securities available for sale (24,255) (18,758) Purchases of investment securities held to maturity (358) (1,326) Proceeds from sales of investment securities available for sale 5,079 --- Maturities of investment securities available for sale 8,101 19,965 Maturities or calls of investment securities held to maturity 1,561 11,256 Purchases of premises and equipment, net (685) (267) Proceeds from sale of other real estate owned --- 512 --------------------------------- Net cash from investing activities (16,509) 1,248 Cash flows from financing activities: Net change in noninterest bearing demand deposits 19,609 (2,921) Net change in interest bearing transaction accounts (1,437) (4,595) Net change in time deposits 29,567 (1,017) Net change in short-term borrowings 1,953 1,842 Issuance of trust preferred securities --- 10,000 Repurchases of common stock (1,146) (14,451) Cash dividends paid (1,403) (371) --------------------------------- Net cash from financing activities 47,143 (11,513) --------------------------------- Net change in cash and cash equivalents 33,328 (6,719) Cash and cash equivalents at beginning of period 24,249 43,927 --------------------------------- Cash and cash equivalents at end of period $57,577 $37,208 ================================= (Continued) This page is page 6 of 40 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) (unaudited) (Continued) Six Months Ended June 30, 2002 2001 ---------------- --------------- Supplemental Disclosures: Cash paid during the period for: Interest expense $4,701 $6,965 Income taxes 2,393 2,535 See Notes to Consolidated Financial Statements. (Concluded) This page is page 7 of 40 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Notes to Consolidated Financial Statements (Unaudited) 1. Basis of Presentation The accompanying unaudited consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes contained in Redwood Empire Bancorp's 2001 Annual Report to Shareholders. The statements include the accounts of Redwood Empire Bancorp ("Redwood," and with its subsidiaries, the "Company"), and its wholly owned subsidiaries, National Bank of the Redwoods ("NBR" or the "Bank") and Redwood Statutory Trust I ("RSTI"). All significant inter-company balances and transactions have been eliminated. The financial information contained in this report reflects all adjustments, which, in the opinion of management, are necessary for a fair presentation of the results of the interim periods. All such adjustments are of a normal recurring nature. The results of operations and cash flows for the six months ended June 30, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. Certain reclassifications were made to prior period financial statements to conform to current period presentations. For purposes of reporting cash flows, cash and cash equivalents include cash on hand, amounts due from banks, federal funds sold and repurchase agreements with original maturities of 90 days or less. Federal funds sold and repurchase agreements are generally for one day periods. 2. Earnings per Share Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. On September 20, 2001, the Company announced a three-for-two stock split of its outstanding shares of common stock. Earnings per share information for all periods presented give effect to the stock split. This page is page 8 of 40 pages. The following table reflects the Company's pertinent earnings per share data. The weighted average shares outstanding have been restated to give effect to the 2001 three-for-two stock split. Three Months Ended June 30, 2002 2001 -------------------------- ------------------------- Basic Diluted Basic Diluted ------------ ------------- ----------- ------------- (in thousands, except per share data) Earnings per common share: Net income $2,025 $2,025 $1,768 $1,768 Earnings per share .58 .56 .49 .47 Weighted average common shares outstanding 3,491,000 3,617,000(1) 3,621,000 3,733,500(1) 1) The weighted average common shares outstanding include the dilutive effects of common stock options of 126,000 and 112,500 for the three months ended June 30, 2002 and June 30, 2001. Six Months Ended June 30, 2002 2001 -------------------------- ------------------------- Basic Diluted Basic Diluted ------------ ------------- ----------- ------------- (in thousands, except per share data) Earnings per common share: Net income $3,972 $3,972 $3,555 $3,555 Earnings per share 1.14 1.10 .92 .90 Weighted average common shares outstanding 3,495,000 3,624,000(1) 3,850,500 3,967,500(1) 1) The weighted average common shares outstanding include the dilutive effects of common stock options of 129,000 and 117,000 for the six months ended June 30, 2002 and June 30, 2001. 3. Comprehensive Income The Company's total comprehensive earnings presentation is as follows: Three Months Ended Six Months Ended June 30, June 30, 2002 2001 2002 2001 ------------------------------------------------ (in thousands) Net income as reported $2,025 $1,768 $3,972 $3,555 Other comprehensive income (net of tax): Change in unrealized holding gain/(losses) on available for sale securities 672 (14) 459 454 Reclassification adjustment --- --- (22) --- ----------------------- ----------------------- Total comprehensive income $2,697 $1,754 $4,409 $4,009 ======================= ======================= This page is page 9 of 40 pages. 4. Subsequent Event - Common Stock Dividend On July 8, 2002, the Board of Directors declared a quarterly cash dividend of 20 cents per share on the Company's Common Stock. The dividend was payable on July 30, 2002 to shareholders of record on July 18, 2002. 5. Business Segments The Company operates in two principal business segments: core community banking and merchant card services. The Company's core community banking segment includes commercial, commercial real estate, construction and permanent residential lending along with all treasury and depository activities. The Company's merchant card services industry group provides credit card settlement services for approximately 48,000 merchants throughout the United States. The condensed income statements and average assets of the individual segments are set forth in the table below. The information in this table is derived from the internal management reporting system used by management to measure the performance of the segments and the Company. The management reporting system assigns balance sheet and income statement items to each segment based on internal management accounting policies. Net interest income is determined by the Company's internal funds transfer pricing system, which assigns a cost of funds or credit for funds to assets or liabilities based on their type, maturity or repricing characteristics. Noninterest income and expense directly attributable to a segment are assigned to that business. Total other operating expense, including indirect costs, such as overhead, operations and technology expense, are allocated to the segments based on an evaluation of costs for product or data processing. All amounts other than allocations of interest and indirect costs are derived from third parties. The provision for credit losses is allocated based on the required reserves and the net charge-offs for each respective segment. The Company allocates depreciation expense without allocating the related depreciable asset to that segment. Summary financial data by business segment for the indicated periods is as follows: For the quarter ended June 30, 2002 ----------------------------------------------- Merchant Community Card Total Banking Services Company ----------------------------------------------- (in thousands) Total interest income $7,734 $ --- $7,734 Total interest expense 2,395 16 2,411 Interest income/(expense) allocation (176) 176 --- ----------------------------------------------- Net interest income 5,163 160 5,323 Provision for loan losses --- --- --- Total other operating income 596 1,197 1,793 Total other operating expense 3,261 643 3,904 ----------------------------------------------- Income before income taxes 2,498 714 3,212 Provision for income taxes 923 264 1,187 ----------------------------------------------- Net income $1,575 $450 $2,025 =============================================== Total Average Assets $455,964 $27,906 $483,870 =============================================== This page is page 10 of 40 pages. For the quarter ended June 30, 2001 ---------------------------------------------- Merchant Community Card Total Banking Services Company ---------------------------------------------- (in thousands) Total interest income $8,442 $ --- $8,442 Total interest expense 3,614 2 3,616 Interest income/(expense) allocation (263) 263 --- ---------------------------------------------- Net interest income 4,565 261 4,826 Provision for loan losses --- --- --- Total other operating income 533 1,019 1,552 Total other operating expense 2,896 536 3,432 ---------------------------------------------- Income before income taxes 2,202 744 2,946 Provision for income taxes 880 298 1,178 ---------------------------------------------- Net income $1,322 $446 $1,768 ============================================== Total Average Assets $418,208 $25,653 $443,861 ============================================== For the six months ended June 30, 2002 ---------------------------------------------- Merchant Community Card Total Banking Services Company ---------------------------------------------- (in thousands) Total interest income $15,143 $ --- $15,143 Total interest expense 4,813 18 4,831 Interest income/(expense) allocation (332) 332 --- ---------------------------------------------- Net interest income 9,998 314 10,312 Provision for loan losses --- --- --- Total other operating income 1,235 2,376 3,611 Total other operating expense 6,349 1,293 7,642 ---------------------------------------------- Income before income taxes 4,884 1,397 6,281 Provision for income taxes 1,797 512 2,309 ---------------------------------------------- Net income $3,087 $885 $3,972 ============================================== Total Average Assets $449,566 $27,310 $476,876 ============================================== For the six months ended June 30, 2001 ---------------------------------------------- Merchant Community Card Total Banking Services Company ---------------------------------------------- (in thousands) Total interest income $17,495 $ --- $17,495 Total interest expense 7,363 5 7,368 Interest income/(expense) allocation (574) 574 --- ---------------------------------------------- Net interest income 9,558 569 10,127 Provision for loan losses --- --- --- Total other operating income 1,085 1,832 2,917 Total other operating expense 5,999 1,083 7,082 ---------------------------------------------- Income before income taxes 4,644 1,318 5,962 Provision for income taxes 1,875 532 2,407 ---------------------------------------------- Net income $2,769 $786 $3,555 ============================================== Total Average Assets $418,849 $25,125 $443,974 ============================================== This page is page 11 of 40 pages. 6. Common Stock Repurchases and Trust Preferred Issuance In January and February 2001, the Company's Board of Directors authorized the repurchase of up to 10% of the Company's total shares outstanding, or 427,500 shares in January 2001 and 385,500 shares in February 2001, as adjusted for the three-for-two stock split announced September 20, 2001, of which all shares have been repurchased. In August 2001, the Company announced a third authorization to repurchase an additional 355,500 shares, as adjusted for the three-for-two stock split announced September 20, 2001. To date, 102,686 shares have been repurchased, as adjusted for the three-for-two stock split announced September 20, 2001. Under the repurchase program, the Company plans to purchase shares from time to time on the open market and/or in privately negotiated transactions. The first two repurchase authorizations were funded in part with proceeds received from a $10,000,000 pooled trust preferred securities offering concluded on February 22, 2001. The financing, which qualifies for tier 1 capital treatment, for up to 25% of total tier 1 capital, bears an interest rate of 10.20% and is due in 30 years. Debt issuance costs, which amounted to approximately $300,000, are being amortized over the life of the offering. 7. Real Estate Investment Trust On January 15, 2002, NBR formed NBR Real Estate Investment Trust, a Maryland Real Estate Investment Trust. The entity was formed to hold NBR's real estate secured loans and to better organize NBR's marketing and origination of real estate secured lending. 8. New Accounting Pronouncements The Financial Accounting Standards Board (FASB) recently issued Statement of Financial Accounting Standards (SFAS) No. 145 and No. 146. SFAS No. 145 applies for years beginning after May 14, 2002 and may be adopted sooner. SFAS No. 145 covers extinguishments of debt and leases, and includes some minor technical corrections. Under previous accounting guidance, gains or losses from extinguishments of debt were always treated as extraordinary items. Under SFAS No. 145 they will no longer be considered extraordinary, except under very limited conditions. Upon adoption of SFAS No. 145, any prior gains and losses from extinguishments of debt must be reclassified as ordinary gains and losses. Under SFAS No. 145, if a capital lease is modified to become an operating lease, it will be accounted for as a sale-leaseback, by following the accounting guidance of SFAS No. 98, instead of being accounted for as a new lease. SFAS No. 146 covers accounting for costs associated with exit or long-lived asset disposal activities, such as restructurings, consolidation or closing of facilities, lease termination costs or employee relocation or severance costs. SFAS No. 146 replaces Emerging Issues Task Force (EITF) 94-3, and is to be applied prospectively to exit or disposal activities initiated after December 31, 2002, and may be adopted sooner. A company may not restate its previously issued financial statements. SFAS No. 146 requires exit or long-lived asset disposal costs to be recognized as an expense when the liability is incurred and can be measured at fair value, rather than at the date of making a commitment to an exit or disposal plan. Management does not expect the effects of the future adoptions of SFAS No. This page is page 12 of 40 pages. 145 and SFAS No. 146 to be material to the Company's consolidated financial position or results of operations. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Forward-Looking Information This Quarterly Report on Form 10-Q includes forward-looking information which is subject to the "safe harbor" created by Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Act of 1934, as amended. These forward-looking statements (which involve the Company's plans, beliefs and goals, refer to estimates, projections or expectations or use similar terms) involve certain risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. Such risks and uncertainties include, but are not limited to, the following factors (many of which are beyond the Company's ability to control): o Competitive pressure in the banking industry and changes in the regulatory and legislative environment. o Changes in the interest rate environment and volatility of rate sensitive loans and deposits. o A decline in the health of the economy nationally or regionally which could reduce the demand for loans or reduce the value of real estate collateral securing most of the Company's loans or reduce the volume of the Company's merchant credit card processing business. o Uncertainty regarding the economic outlook resulting from the terrorist attacks on September 11, 2001. o Credit quality deterioration, which could cause an increase in the provision for loan losses. o Dividend restrictions. o Regulatory discretion. o Material losses in the Company's merchant credit card processing business from merchant or card holder fraud or merchant business failure and the ability of the Company to comply with the rules and regulations of the major credit card associations, such as Visa and Mastercard, as described under "Certain Important Considerations for Investors" in this report. o Asset/liability repricing risks and liquidity risks. o Changes in the securities markets. This page is page 13 of 40 pages. o A decline in the health of the Northern California economy as a result of shortages of electrical power or increases in energy costs. o Certain operational risks involving data processing systems or fraud. Any forward-looking statements made by the Company are intended to provide investors with additional information with which they may assess the Company's future potential. All forward-looking statements are based on assumptions about an uncertain future and are based on information available at the date such statements are issued. The Company undertakes no obligation to revise or publicly release the results of any revision to these forward-looking statements. For additional information concerning risks and uncertainties related to the Company and its operations, please refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2001 and "Certain Important Considerations for Investors" herein. The following sections discuss significant changes and trends in financial condition, capital resources and liquidity of the Company from December 31, 2001 to June 30, 2002. Significant changes and trends in the Company's results of operations for the three and six months ended June 30, 2002, compared to the same period in 2001, are also discussed. Summary of Financial Results The Company reported net income of $2,025,000 ($.56 per diluted share) for the three months ended June 30, 2002 as compared to $1,768,000 ($.47 per diluted share) for the same period in 2001, an increase of $257,000 in net income or 15%. This increase is due to an increase of $241,000 in noninterest income and an increase of $497,000 in net interest income, partially offset by an increase of $472,000 in noninterest expense. In addition, net income increased due to a decline in the Company's effective tax rate from 39.99% for the quarter ended June 30, 2001 to 36.96% for the quarter ended June 30, 2002. For further information, see "Income Taxes" in this section. Net income for the six months ended June 30, 2002 was $3,972,000 ($1.10 per diluted share) as compared to $3,555,000 ($.90 per diluted share) for the same period in 2001, an increase of $417,000 in net income or 12%. This increase is due to an increase of $694,000 in noninterest income and an increase of $185,000 in net interest income, partially offset by an increase of $560,000 in noninterest expense. On September 20, 2001, the Company announced a three-for-two stock split of its outstanding shares of common stock. Earnings per share information for all periods presented give effect to the stock split. This page is page 14 of 40 pages. Net Interest Income Net interest income increased from $4,826,000 in the second quarter of 2001 to $5,323,000 in the second quarter of 2002, which represents an increase of $497,000 or 10%. The increase in net interest income was driven by an increase in average earning assets of $38,282,000 from $415,645,000 for the quarter ended June 30, 2001 to $453,927,000 for the quarter ended June 30, 2002. The net interest margin for the second quarter of 2002 also improved to 4.70% from 4.66% one year ago. Net interest income for the six months ended June 30, 2002 was $10,312,000, which represents an increase of $185,000 when compared to the same period one year ago. The Company's net interest margin decreased to 4.64% for the six months ended June 30, 2002, as compared to 4.91% for the six months ended June 30, 2001. The decline in net interest margin during the six-month period of 2002 is due to the lower interest rate environment and the full six month impact of the Company's February 22, 2001 trust preferred debt financing. For further discussion of this matter, see 'Trust Preferred Securities' in this section. For the three months ended June 30, 2002, yield on earning assets decreased to 6.83% from 8.15% for the same period one year ago. The decrease in yield on earning assets is due to a decline in the general interest rate environment. Despite the decline in interest rates, average portfolio loans increased $32,509,000 or 10%, when compared to the same quarter in 2001. Average commercial real estate loans increased $29,196,000 or 29% and average installment and other loans increased $3,372,000 or 33% for the three months ended June 30, 2002 as compared to the three months ended June 30, 2001. For the six months ended June 30, 2002, yield on earning assets decreased to 6.82% as compared to 8.48% for the six months ended June 30, 2001. While the Company has seen average earning assets grow to $447,790,000 for the six months ended June 30, 2002, as compared to $416,066,000 for the six months ended June 30, 2001, the decline in yield on earning assets is attributable to the decline in the general interest rate environment. Average portfolio loans increased $31,065,000 or 10% when compared to the same period in 2001. Average commercial real estate loans increased $26,940,000 or 27% and average installment and other loans increased $4,241,000 or 45% for the six months ended June 30, 2002 as compared to the six months ended June 30, 2001. Yield paid on interest bearing liabilities decreased to 2.78% and 2.82% for the three and six months ended June 30, 2002 as compared to 4.51% and 4.65% for the same periods one year ago. This decline is attributable to a lower interest rate environment as discussed above. With the increase in average earning assets in the first six months of 2002, the Company's funding levels also increased as average interest bearing liabilities increased $25,390,000 or 8% as compared to the same period one year ago. The average balance of time deposits increased $21,789,000 during the first six months of 2002 as compared to the same period one year ago. The growth in time deposits in 2002 is a result of the Company's efforts to fund earning asset growth and build its deposit portfolio. In addition to growth in interest bearing deposits, average non interest bearing demand deposits increased $11,684,000 or 13% for the quarter ended June 30, 2002 when compared to the same quarter one year ago. This page is page 15 of 40 pages. The following is an analysis of the Company's net interest margin for the indicated periods: Three months ended Three months ended June 30, 2002 June 30, 2001 ------------------------------------- ------------------------------------ Average % Average % (dollars in thousands) Balance Interest Yield/Rate Balance Interest Yield/Rate ------------------------------------- ------------------------------------ Commercial loans $70,320 $1,204 6.87% $73,152 $1,664 9.12% Real estate-mortgage loans 93,107 1,673 7.21 93,736 1,923 8.23 Real estate-commercial loans 131,313 2,542 7.76 102,117 2,263 8.89 Construction loans 43,499 902 8.32 40,294 934 9.30 Installment and other 13,743 163 4.76 10,371 183 7.08 Deferred loan fees (659) --- --- (856) --- --- ----------------------- ---------------------- Portfolio loans 351,323 6,484 7.40 318,814 6,967 8.77 Mortgage loans held for sale 147 2 5.46 --- --- --- Investments 76,050 1,128 5.95 74,546 1,212 6.52 Federal funds sold 26,407 120 1.82 22,285 263 4.73 ----------------------- ---------------------- Total earning assets (1) $453,927 7,734 6.83 $415,645 8,442 8.15 ============= ============= Interest bearing transaction accounts $122,311 $446 1.46 $123,727 782 2.54 Time deposits 211,333 1,686 3.20 184,540 2,551 5.54 Other borrowings 13,960 279 8.02 13,211 283 8.59 ----------------------- ---------------------- Total interest-bearing liabilities $347,604 2,411 2.78% $321,478 3,616 4.51% ============= ============= ----------- ---------- Net interest income $5,323 $4,826 =========== ========== Net interest income to earning assets 4.70% 4.66% This page is page 16 of 40 pages. Six months ended Six months ended June 30, 2002 June 30, 2001 ----------------------------------- ----------------------------------- Average % Average % (dollars in thousands) Balance Interest Yield/Rate Balance Interest Yield/Rate ----------------------------------- ----------------------------------- Commercial loans $69,838 $2,402 6.94% $70,773 $3,409 9.71% Real estate-mortgage loans 95,087 3,382 7.17 95,820 3,932 8.28 Real estate-commercial loans 127,225 4,835 7.66 100,285 4,452 8.95 Construction loans 44,547 1,765 7.99 43,300 2,202 10.26 Installment and other 13,683 316 4.66 9,442 361 7.71 Deferred loan fees (591) --- --- (896) --- --- ------------------------ ------------------------ Portfolio loans 349,789 12,700 7.32 318,724 14,356 9.08 Mortgage loans held for sale 91 3 6.65 --- --- --- Investments 72,523 2,216 6.16 76,235 2,599 6.87 Federal funds sold 25,387 224 1.78 21,107 540 5.16 ------------------------ ------------------------ Total earning assets (1) $447,790 15,143 6.82 $416,066 17,495 8.48 ============== ============== Interest bearing transaction accounts $123,343 868 1.42 $123,907 1,630 2.65 Time deposits 207,837 3,426 3.32 186,048 5,303 5.75 Other borrowings 14,064 537 7.70 9,899 435 8.86 ------------------------ ------------------------ Total interest-bearing liabilities $345,244 4,831 2.82% $319,854 7,368 4.65% ============== ============== ----------- ----------- Net interest income $10,312 $10,127 =========== =========== Net interest income to earning assets 4.64% 4.91% (1) Nonaccrual loans are included in the calculation of the average balance of earning assets (interest not accrued is excluded). This page is page 17 of 40 pages. The following table sets forth changes in interest income and interest expense for each major category of interest-earning asset and interest-bearing liability, and the amount of change attributable to volume and rate changes for the three and six months ended June 30, 2002 and 2001. Changes not solely attributable to rate or volume have been allocated proportionately to the change due to volume and the change due to rate. Three months ended June 30, 2002 compared to the three months ended June 30, 2001 ---------------------------------------- Volume Rate Total ---------------------------------------- (in thousands) Increase/(decrease) in interest income: Commercial loans ($62) ($398) ($460) Real estate-mortgage loans (13) (237) (250) Real estate-commercial loans 590 (311) 279 Construction loans 71 (103) (32) Installment and other 50 (70) (20) Mortgage loans held for sale 2 --- 2 Investments 24 (108) (84) Federal funds sold 42 (185) (143) ---------------------------------------- Total increase/(decrease) 704 (1,412) (708) ---------------------------------------- Increase/(decrease) in interest expense: Interest-bearing transaction accounts (9) (327) (336) Time deposits 330 (1,195) (865) Other borrowings 16 (20) (4) ---------------------------------------- Total increase/decrease) 337 (1,542) (1,205) ---------------------------------------- Increase/(decrease) in net interest income $367 $130 $497 ======================================== Six months ended June 30, 2002 compared to the six months ended June 30, 2001 ---------------------------------------- Volume Rate Total ---------------------------------------- (in thousands) Increase/(decrease) in interest income: Commercial loans ($44) ($963) ($1,007) Real estate-mortgage loans (30) (520) (550) Real estate-commercial loans 1,084 (701) 383 Construction loans 62 (499) (437) Installment and other 128 (173) (45) Mortgage loans held for sale 3 --- 3 Investments (122) (261) (383) Federal funds sold 93 (409) (316) ---------------------------------------- Total increase/(decrease) 1,174 (3,526) (2,352) ---------------------------------------- Increase/ (decrease) in interest expense: Interest-bearing transaction accounts (7) (755) (762) Time deposits 564 (2,441) (1,877) Other borrowings 165 (63) 102 ---------------------------------------- Total increase/ (decrease) 722 (3,259) (2,537) ---------------------------------------- Increase/(decrease) in net interest income $452 ($267) $185 ======================================== This page is page 18 of 40 pages. Provision for Loan Losses Due to the absence of significant net loan charge-offs, little change in loan portfolio asset quality and the balance in the allowance for loan losses, there was no provision for loan losses for the three and six months ended June 30, 2002 and 2001. For further information, see "Allowance for Loan Losses" and "Nonperforming Assets" in this section. Noninterest Income and Expense and Income Taxes Noninterest Income The following tables set forth the components of the Company's noninterest income for the three and six months ended June 30, 2002, as compared to the same period in 2001. Three Months Ended June 30, $ % ------------------------------ 2002 2001 Change Change ------------ ------------- -------------------------- (dollars in thousands) Service charges on deposit accounts $308 $266 $42 16% Merchant draft processing, net 1,197 1,019 178 17 Loan servicing income 81 80 1 1 Other income 207 187 20 11 ------------ ------------- ------------- Total noninterest income $1,793 $1,552 $241 16% ============ ============= ============= Noninterest income increased $241,000, or 16%, to $1,793,000 for the three months ended June 30, 2002 when compared to $1,552,000 for the same period in 2001. During this period, such increase was primarily due to an increase of $178,000 in merchant card net revenue, and an increase in service charges of $42,000. The increase in merchant card net revenue is due to an increase in processing revenue brought about by the Company's efforts to build its overall merchant card services business through direct marketing efforts and new independent sales organization (ISO) relationships. Six Months Ended June 30, $ % ------------------------------ 2002 2001 Change Change ------------ ------------ ---------------------------- (dollars in thousands) Service charges on deposit accounts $622 $535 $87 16% Merchant draft processing, net 2,376 1,832 544 30 Loan servicing income 135 157 (22) (14) Net realized gains on investment securities available for sale 35 --- 35 --- Other income 443 393 50 13 ------------ ------------ -------------- Total noninterest income $3,611 $2,917 $694 24% ============ ============ ============== This page is page 19 of 40 pages. Noninterest income increased $694,000, or 24%, to $3,611,000 for the six months ended June 30, 2002 when compared to $2,917,000 for the same period in 2001. During this period, such increase was primarily due to an increase of $544,000 in merchant card net revenue, an increase in service charges of $87,000 and an increase in other income of $50,000. The increase in merchant card net revenue is due to an increase in processing revenue, as discussed above. Noninterest Expense The following tables set forth the components of the Company's noninterest expense during the three and six months ended June 30, 2002, as compared to the same period in 2001. Three Months Ended June 30, $ % ------------------------- 2002 2001 Change Change ------------ ------------ --------------------- (dollars in thousands) Salaries and employee benefits $2,302 $1,989 $313 16 % Occupancy and equipment expense 533 503 30 6 Other 1,069 940 129 14 -------------- ------------ ----------- Total noninterest expense $3,904 $3,432 $472 14 % ============== ============ =========== Noninterest expense increased by $472,000, or 14%, to $3,904,000 during the second quarter of 2002 as compared to $3,432,000 for the second quarter of 2001. The increase in noninterest expense for the three-month period ended June 30, 2002, as compared to the same period ended June 30, 2001, was primarily attributable to an increase in salaries and employee benefits of $313,000 and an increase in other expense of $129,000. The increase in salaries and employee benefits was primarily due to an increase in the number of full time equivalent employees employed by the Company. At June 30, 2002, the number of full time equivalent employees totaled 155 as compared to 145 at June 30, 2001. Other expenses increased during the period partially as a result of computer system improvements and expenses incurred in association with NBR Real Estate Trust, as described below. Six Months Ended June 30, $ % ------------------------ 2002 2001 Change Change ------------ ----------- --------------------- (dollars in thousands) Salaries and employee benefits $4,348 $4,221 $127 3% Occupancy and equipment expense 1,057 992 65 7 Other 2,237 1,869 368 20 ------------ ------------ ----------- Total noninterest expense $7,642 $7,082 $560 8% ============ ============ =========== Noninterest expense increased by $560,000, or 8%, to $7,642,000 during the six months ended June 30, 2002 as compared to $7,082,000 for the same period one year ago. The increase in noninterest expense was due to an increase in salaries and employee benefits of $127,000 and This page is page 20 of 40 pages. an increase in other expense of $368,000. The increase in salaries and employee benefits was primarily due to the increase in the number of full time equivalent employees, as described above. Other expenses increased during 2002 partially as a result of technological improvements made to the Company's internal computer systems and expenses incurred in association with the formation of NBR Real Estate Investment Trust. Income Taxes The Company's effective tax rate varies with changes in the relative amounts of its non-taxable income and nondeductible expenses. The effective tax rate was 36.96% and 36.76% for the three and six months ended June 30, 2002, as compared to 39.99% and 40.37% for the same periods in 2001. On January 15, 2002, NBR formed NBR Real Estate Investment Trust, a Maryland Real Estate Investment Trust. The entity was formed to hold NBR's real estate secured loans and to better organize NBR's marketing and origination of real estate secured lending. In addition, the favorable state income tax treatment on the income of this trust resulted in a reduction of the Company's effective tax rate. Business Segments The Company operates in two principal product and service lines: core community banking and merchant credit card services. The Company's core community banking segment includes commercial, commercial real estate, construction and permanent residential lending along with treasury and depository activities. The Company's merchant card services industry group provides credit card settlement services for approximately 48,000 merchants throughout the United States. Summary financial data by business segment for the indicated periods is as follows: For the quarter ended June 30, 2002 ----------------------------------------------- Merchant Community Card Total Banking Services Company ----------------------------------------------- (in thousands) Total interest income $7,734 $ --- $7,734 Total interest expense 2,395 16 2,411 Interest income/(expense) allocation (176) 176 --- ----------------------------------------------- Net interest income 5,163 160 5,323 Provision for loan losses --- --- --- Total other operating income 596 1,197 1,793 Total other operating expense 3,261 643 3,904 ----------------------------------------------- Income before income taxes 2,498 714 3,212 Provision for income taxes 923 264 1,187 ----------------------------------------------- Net income $1,575 $450 $2,025 =============================================== Total Average Assets $455,964 $27,906 $483,870 =============================================== This page is page 21 of 40 pages. For the quarter ended June 30, 2001 ------------------------------------------------ Merchant Community Card Total Banking Services Company ------------------------------------------------ (in thousands) Total interest income $8,442 $ --- $8,442 Total interest expense 3,614 2 3,616 Interest income/(expense) allocation (263) 263 --- ------------------------------------------------ Net interest income 4,565 261 4,826 Provision for loan losses --- --- --- Total other operating income 533 1,019 1,552 Total other operating expense 2,896 536 3,432 ------------------------------------------------ Income before income taxes 2,202 744 2,946 Provision for income taxes 880 298 1,178 ------------------------------------------------ Net income $1,322 $446 $1,768 ================================================ Total Average Assets $418,208 $25,653 $443,861 ================================================ For the six months ended June 30, 2002 ---------------------------------------------- Merchant Community Card Total Banking Services Company ---------------------------------------------- (in thousands) Total interest income $15,143 $ --- $15,143 Total interest expense 4,813 18 4,831 Interest income/(expense) allocation (332) 332 --- ---------------------------------------------- Net interest income 9,998 314 10,312 Provision for loan losses --- --- --- Total other operating income 1,235 2,376 3,611 Total other operating expense 6,349 1,293 7,642 ---------------------------------------------- Income before income taxes 4,884 1,397 6,281 Provision for income taxes 1,797 512 2,309 ---------------------------------------------- Net income $3,087 $885 $3,972 ============================================== Total Average Assets $449,566 $27,310 $476,876 ============================================== For the six months ended June 30, 2001 ---------------------------------------------- Merchant Community Card Total Banking Services Company ---------------------------------------------- (in thousands) Total interest income $17,495 $ --- $17,495 Total interest expense 7,363 5 7,368 Interest income/(expense) allocation (574) 574 --- ---------------------------------------------- Net interest income 9,558 569 10,127 Provision for loan losses --- --- --- Total other operating income 1,085 1,832 2,917 Total other operating expense 5,999 1,083 7,082 ---------------------------------------------- Income before income taxes 4,644 1,318 5,962 Provision for income taxes 1,875 532 2,407 ---------------------------------------------- Net income $2,769 $786 $3,555 ============================================== Total Average Assets $418,849 $25,125 $443,974 ============================================== This page is page 22 of 40 pages. Community Banking The Community Banking segment's income before income tax increased for the three and six months ended June 30, 2002 when compared to the same period in 2001. The increase was primarily due to an increase in net interest income. Net interest income increased $598,000 and $440,000 for the three and six months ended June 30, 2002, principally due to an increase in earning assets, offset by a decline in the general interest rate environment and the issuance of pooled trust preferred debt securities, which have been fully allocated to the Community Banking segment. The Company increased its loan portfolio during the first six months of 2002 through renewed marketing efforts. For the quarter ended June 30, 2002, total average portfolio loans were $351,323,000, up 10% from $318,814,000 for the quarter ended June 30, 2001. Merchant Card Services The Company's merchant credit card segment earned $450,000 and $885,000 for the three and six months ended June 30, 2002 compared to $446,000 and $786,000 for the same periods in 2001. The increase in the unit's net income was due to an increase in processing revenue brought about by the Company's efforts to build its overall merchant card services business through direct marketing efforts and new independent sales organization (ISO) relationships. The merchant credit card segment's net income comprised approximately 22% of the Company's consolidated net income for the three and six months ended June 30, 2002 as compared to 25% and 22% for the same periods one year ago. The Company bears certain risks associated with its merchant credit card processing business. Due to a contractual obligation between NBR and Visa and MasterCard, NBR stands in the place of the merchant in the event that a merchant refuses or is unable to pay charge-backs from cardholders. As a result of this obligation, NBR may incur losses associated with its merchant credit card processing business. Accordingly, NBR has established a reserve to provide for losses associated with charge-back losses. Such reserve, which totaled $1,251,000 and $1,240,000 as of June 30, 2002 and 2001, was estimated based upon industry loss data as a percentage of transaction volume throughout each year, historical losses incurred by the Company and management's evaluation regarding merchant and ISO risk. The Company utilizes the services of ISOs to acquire merchants as customers. The provision for charge-back losses, which is included in the financial statements as a reduction in merchant draft processing income, was $49,000 and $108,000 for the three and six months ended June 30, 2002, as compared to $54,000 and $74,000 for the same periods ended June 30, 2001. For further discussion, see "Certain Important Considerations for Investors" in this section. This page is page 23 of 40 pages. The following table summarizes the Company's merchant card allowance for charge-back losses for the periods indicated: Three months ended Six months ended June 30, June 30, 2002 2001 2002 2001 -------------------------------------------------- (in thousands) Beginning allowance $1,233 $1,266 $1,212 $1,276 Provision for losses 49 54 108 74 Recoveries 3 33 11 79 Charge-offs (34) (113) (80) (189) ------------------------- ------------------------ Ending allowance $1,251 $1,240 $1,251 $1,240 ========================= ======================== Investment Securities Total investment securities increased to $75,553,000, as of June 30, 2002, compared to $64,975,000 as of December 31, 2001. The Company's average federal funds sold position was $25,387,000 for the first six months of 2002 as compared to $21,107,000 for the same period in 2001. Growth of the investment securities portfolio and the Company's overnight investment position was driven by the need to invest proceeds from the Company's deposit growth. Loans Total loans increased to $357,862,000 at June 30, 2002 compared to $351,649,000 at December 31, 2001. The Company's residential loan portfolio has experienced substantial paydown activity during the first six months of 2002. Despite this paydown activity, the Company continues to focus on growth in the overall loan portfolio through marketing efforts and a general expansion of businesses within the Company's market area. Commercial real estate loans increased $18,564,000 to $140,020,000, at June 30, 2002, compared to $121,456,000 at December 31, 2001. The following table summarizes the composition of the loan portfolio at June 30, 2002 and December 31, 2001: June 30, 2002 December 31, 2001 ---------------------------- ----------------------------- Amount % Amount % ---------------------------- ----------------------------- (dollars in thousands) Residential real estate mortgage $93,698 26% $101,175 29% Commercial real estate mortgage 140,020 40 121,456 34 Commercial 69,464 19 70,438 20 Real estate construction 43,152 12 46,501 13 Installment and other 12,223 3 12,567 4 Less net deferred loan fees (695) --- (488) --- ---------------------------- ----------------------------- Total portfolio loans 357,862 100% 351,649 100% ========== ============ Less allowance for loan losses (7,586) (7,580) ------------------- ------------------ Net loans $350,276 $344,069 =================== ================== This page is page 24 of 40 pages. Allowance for Loan Losses The allowance for loan losses is established through charges to earnings in the form of the provision for loan losses. Loan losses are charged to, and recoveries are credited to, the allowance for loan losses. The provision for loan losses is determined after considering various factors such as loan loss experience, current economic conditions, maturity of the portfolio, size of the portfolio, industry concentrations, borrower credit history, the existing allowance for loan losses, independent loan reviews, current charges and recoveries to the allowance for loan losses and the overall quality of the portfolio, as determined by management, regulatory agencies and independent credit review consultants retained by the Company. The Company's allowance for loan losses is based on specific and formula allocations to the Company's loan portfolio. Specific allocations of the allowance for loan losses are made to identified problem loans where management has identified significant conditions or circumstances related to a given loan, which management believes indicates the probability that a loss may occur. The specific allocations are increased or decreased through management's reevaluation on a quarterly basis of the status of the particular problem loans. Loans which do not receive a specific allocation receive an allowance allocation based on a formula, represented by a percentage factor based on underlying collateral, type of loan, historical charge-offs, general economic conditions and other qualitative factors. The following table summarizes changes in the Company's allowance for loan losses for the indicated periods: Three months ended Six months ended June 30, June 30 ------------------------- -------------------------- 2002 2001 2002 2001 ------------------------- -------------------------- (dollars in thousands) Beginning allowance for loan losses $7,549 $7,696 $7,580 $7,674 Provision for loan losses --- --- --- --- Charge-offs --- (2) (45) (2) Recoveries 37 10 51 32 ------------------------- -------------------------- Ending allowance for loan losses $7,586 $7,704 $7,586 $7,704 ========================= ========================== Net charge-offs/(recoveries) to average loans (annualized) (0.04%) (0.01%) (0.01%) (0.02%) The allowance for loan losses as a percentage of total loans decreased slightly from 2.16%, at December 31, 2001, to 2.12% at June 30, 2002. The growth in the Company's loan portfolio is primarily comprised of commercial real estate loans that generally bear a lower credit risk than construction or commercial loans. Accordingly, under the Company's loan loss reserve methodology, such loans generally receive a lower loan loss reserve allocation as compared to commercial or construction loans. This page is page 25 of 40 pages. Nonperforming Assets The following table summarizes the Company's nonperforming assets at the dates indicated: June 30, December 31, 2002 2001 ---------------- --------------- (dollars in thousands) Nonaccrual loans $1,765 $2,892 Accruing loans past due 90 days or more 616 --- Restructured loans 280 284 ---------------- --------------- Total nonperforming loans 2,661 3,176 Other real estate owned --- --- ---------------- --------------- Total nonperforming assets $2,661 $3,176 ================ =============== Nonperforming assets to total assets 0.53% 0.71% Nonperforming assets have decreased slightly from $3,176,000 or .71% of total assets, as of December 31, 2001, to $2,661,000 or .53% of total assets as of June 30, 2002. The decrease was attributable to a decrease of $1,127,000 in nonaccrual loans during this period. At June 30, 2002, nonperforming loans consist of loans to 12 borrowers, 4 of which have balances in excess of $100,000. The two largest have recorded balances of $632,000 and $463,000. One property is secured by commercial real estate, the other by commercial property. Based on information currently available, management believes that adequate reserves are included in the allowance for loan losses to cover any loss exposure that may result from these loans. At June 30, 2002, the Company did not have any properties classified as other real estate owned. Although the volume of nonperforming assets will depend in part on the future economic environment, there is one loan relationship which totals approximately $947,000 as of June 30, 2002, compared to three loan relationships totaling approximately $1,921,000 at December 31, 2001, about which management has serious doubts as to the ability of the borrower to comply with the present repayment terms. This loan may become a nonperforming asset based on the information presently known about possible credit problems of the borrower. At June 30, 2002, the Company's total recorded investment in impaired loans (as defined by SFAS 114 and 118) was $2,661,000, of which $2,381,000 relates to the recorded investment in loans for which there is a related allowance for loan losses of $243,000. The remaining $280,000 in impaired loans did not require a specific allowance for loan losses. This page is page 26 of 40 pages. The Company's average recorded investment in impaired loans during the six months ended June 30, 2002 and 2001 was $2,056,000 and $1,358,000. The increase of $698,000 in the average recorded investment in impaired loans during the six months ending June 30, 2002 compared to the same period one year ago was primarily due to growth in nonperforming loans. Interest income recognized during the periods that such loans were impaired for the six months ended June 30, 2002 was $32,000, as compared to $15,000 and $44,000 for the three and six months ended June 30, 2001. There was no interest income recognized during the three months ended June 30, 2002. As of June 30, 2002, there was $1,765,000 of loans on which the accrual of interest had been discontinued as compared to $2,892,000 at December 31, 2001. During the three and six months ended June 30, 2002, interest due but excluded from interest income on loans placed on nonaccrual status was $11,000 and $47,000, as compared to $23,000 and $41,000 for the same periods one year ago. There was no interest income received on nonaccrual loans during the three and six months ended June 30, 2002, as compared to $2,000 and $5,000 during the three and six months ended June 30, 2001. Mortgage Repurchase Commitments From time to time the Company may be required to repurchase mortgage loans from mortgage loan investors as a result of breaches of representations and warranties in the purchase agreement between the investor and the Company. The Company may also be required to reimburse a mortgage loan investor for losses incurred as a result of liquidating collateral, which had secured a mortgage loan sold by the Company. Such representations and warranties include the existence of a valid appraisal, status of borrower or fraud. In the first six months of 2002, the Company was not required to repurchase any such loans. The Company maintains a reserve for management's estimate of potential losses associated with the repurchase of previously sold mortgage loans. During the first quarter of 2002, the Company agreed to pay $33,000 for a settlement related to disputed title issues. Reserves for such losses totaled $60,000 as of June 30, 2002 and $93,000 as of December 31, 2001. The Company expects that it may be required to repurchase loans in the future. Investment in REMIC In 1995, Allied Savings Bank ("Allied"), formerly a wholly owned subsidiary of the Company which merged into NBR in 1997, sold a COFI ARM mortgage pool whose carrying value was approximately $73,900,000 as part of a transaction that resulted in creating a Real Estate Mortgage Investment Conduit ("REMIC"). The REMIC issued three classes of mortgage pass-through mortgage certificates: A, B and C. The sale transaction took place as a result of Allied selling 100% interest in the COFI indexed ARM mortgage pool in exchange for cash of $71,500,000 and a Class B certificate which represented the first loss position with respect to any ultimate losses realized upon the liquidation of defaulted mortgage loans in the pool. As part of the sale transaction, Allied retained the servicing of the pool. The Class A and Class B certificates have sequential rights to principal payments, such that Class B certificates shall only receive principal payments after all Class A certificates are retired. This page is page 27 of 40 pages. The composition of the original certificate balances along with their respective June 30, 2002 balances are as follows: Original June 30, 2002 Certificate Certificate Face Value Face Value ------------------------------ Class A $73,199,448 $3,192,642 Class B 3,249,067 3,196,478 Class C 100 100 ------------------------------ Total pool $76,448,615 $6,389,220 ============================== Since inception the pool has realized losses of $52,590, which reduced the original face value of the Class B certificate. Management believes that the difference between the carrying amount of the Class B certificate of $3,172,374 and its face value of $3,196,478 is sufficient to absorb any future realized losses in the pool. Contractual Obligations and Commitments The following table presents the Company's longer term, non-deposit related, contractual obligations and commitments to extend credit to our borrowers, in aggregate and by payment due dates. June 30, 2002 ---------------------------------------------------------------------- Less Than One Through Four Through After Five One Year Three Years Five Years Years Total ---------------------------------------------------------------------- (in thousands) Trust preferred securities $ --- $ --- $ --- $10,000 $10,000 Operating leases (premises) 1,362 1,467 429 273 3,531 ---------------------------------------------------------------------- Total long-term debt and operating leases $1,362 $1,467 $429 $10,273 $13,531 ========================================================= Commitments to extend credit 75,004 Standby letters of credit 373 -------------- Total contractual obligations and commitments $88,908 ============== This page is page 28 of 40 pages. Liquidity Redwood's primary source of liquidity is dividends from NBR. Redwood's primary uses of liquidity have historically been associated with common stock repurchases, dividend payments made to common stock holders, interest payments relating to Redwood's trust preferred securities and operating expenses. It is Redwood's general policy to maintain liquidity at the parent level which management believes to be consistent with the safety and soundness of the Company as a whole. As of June 30, 2002, Redwood held $198,000 in deposits at NBR. Redwood's current cash dividend to its common shareholders is $.20 per common share per quarter. Further, Redwood is required to make semi-annual payments of interest at 10.2% on $10,000,000 of trust preferred securities issued in 2001. Payment of these obligations is ultimately dependent on dividends from NBR to Redwood. Federal regulatory agencies have the authority to prohibit the payment of dividends by NBR to Redwood if a finding is made that such payment would constitute an unsafe or unsound practice or if NBR would become undercapitalized as a result. If NBR is restricted from paying dividends, Redwood might be unable to pay dividends to its common shareholders. No assurance can be given as to the ability of NBR to pay dividends to Redwood in the future. The approval of the Office of the Comptroller of the Currency ("OCC"), is required for the payment of dividends if the total of all dividends declared by a national bank in any calendar year would exceed the total of its net profits of that year combined with its retained net profits of the two preceding years, less any required transfers to surplus or a fund for the retirement of any preferred stock. Due to this requirement, NBR obtained such approval for its 2002 dividend plan from the OCC in January 2002. During the first six months of 2002, NBR declared a dividend payable to Redwood of $3,400,000. Management believes that as of June 30, 2002, the Company's liquidity position was adequate for the operations of Redwood and NBR. Although each entity within the consolidated Company manages its own liquidity, the Company's consolidated cash flow can be divided into three distinct areas: operating, investing and financing. For the six months ended June 30, 2002, the Company received cash of $2,694,000 from operating activities and $47,143,000 from financing activities, while using $16,509,000 in investing activities. Capital Resources A strong capital base is essential to the Company's continued ability to service the needs of its customers. Capital protects depositors and the FDIC deposit insurance fund from potential losses and is a source of funds for the substantial investments necessary for the Company to remain competitive. In addition, adequate capital and earnings enable the Company to gain access to the capital markets to supplement its internal growth of capital. Capital is generated internally primarily through earnings retention. This page is page 29 of 40 pages. The Company and NBR are required to maintain minimum capital ratios defined by various federal government regulatory agencies. The Board of Governors of the Federal Reserve System and the OCC have each established capital guidelines, which include minimum capital requirements. These regulations impose three sets of standards: "risk-based", "leverage" and "tangible" capital. Under the risk-based capital standard, assets reported on an institution's balance sheet and certain off-balance sheet items are assigned to risk categories, each of which is assigned a risk weight. This standard characterizes an institution's capital as being "Tier 1" capital (defined as principally comprising shareholders' equity, trust preferred securities, for up to 25% of total tier 1 capital, and noncumulative preferred stock) and "Tier 2" capital (defined as principally comprising the allowance for loan losses and subordinated debt). Under the leverage capital standard, an institution must maintain a specified minimum ratio of Tier 1 capital to total assets, with the minimum ratio ranging from 4% to 6%. The leverage ratio for the Company and NBR is based on average assets for the quarter. The following table summarizes the consolidated capital ratios and the capital ratios of the principal subsidiaries at June 30, 2002 and December 31, 2001. June 30, 2002 December 31, 2001 -------------------------------------- ----------------------------------- Well- Minimum Well- Minimum Actual Capitalized Requirement Actual Capitalized Requirement -------------------------------------- ----------------------------------- Company Leverage 7.40% 5.00% 4.00% 7.46% 5.00% 4.00% Tier 1 risk-based 9.24 6.00 4.00 9.52 6.00 4.00 Total risk-based 10.71 10.00 8.00 11.16 10.00 8.00 NBR Leverage 7.47% 5.00% 4.00% 7.69% 5.00% 4.00% Tier 1 risk-based 9.31 6.00 4.00 9.82 6.00 4.00 Total risk-based 10.57 10.00 8.00 11.08 10.00 8.00 In January and February 2001, the Company's Board of Directors authorized the repurchase of up to 10% of the Company's total shares outstanding, or 427,500 shares in January 2001 and 385,500 shares in February 2001, as adjusted for the three-for-two stock split announced September 20, 2001, of which all shares have been repurchased. In August 2001, the Company announced a third authorization to repurchase an additional 355,500 shares, as adjusted for the three-for-two stock split announced September 20, 2001. To date, 102,686 shares have been repurchased, as adjusted for the three-for-two stock split announced September 20, 2001. Under the repurchase program, the Company plans to purchase shares from time to time on the open market and/or in privately negotiated transactions. The first two repurchase authorizations were funded in part with proceeds received from a $10,000,000 pooled trust preferred securities offering which concluded on February 22, 2001. This page is page 30 of 40 pages. Trust Preferred Securities On February 22, 2001, Redwood Statutory Trust I ("RSTI"), a wholly owned subsidiary of the Company, closed a pooled offering of 10,000 Capital Securities with a liquidation amount of $1,000 per security. The proceeds of the offering were loaned to the Company in exchange for junior subordinated debentures with terms similar to the Capital Securities. The sole assets of RSTI are the junior subordinated debentures of the Company and payments thereunder. The junior subordinated debentures and the back-up obligations, in the aggregate, constitute a full and unconditional guarantee by the Company of the obligations of RSTI under the Capital Securities. Distributions on the Capital Securities are payable semi-annually at the annual rate of 10.2% and are included in interest expense in the consolidated financial statements. These securities are considered Tier 1 capital (with certain limitations applicable) under current regulatory guidelines. As of June 30, 2002, the outstanding principal balance of the Capital Securities was $10,000,000. The principal balance of the Capital Securities constitutes the trust preferred securities in the financial statements. The junior subordinated debentures are subject to mandatory redemption, in whole or in part, upon repayment of the Capital Securities at maturity or their earlier redemption at the liquidation amount. Subject to the Company having received prior approval of the Federal Reserve, if then required, the Capital Securities are redeemable prior to the maturity date of February 22, 2031, at the option of the Company; on or after February 22, 2021 at par; or on or after February 22, 2011 at a premium; or upon occurrence of specific events defined within the trust indenture. The Company has the option to defer distributions on the Capital Securities from time to time for a period not to exceed 10 consecutive semi-annual periods. Certain Important Considerations for Investors Merchant Credit Card Processing. The Company's profitability can be negatively impacted should any of the Company's merchant credit card customers be unable to pay on charge-backs from cardholders. Due to a contractual obligation between the NBR and Visa and Mastercard, NBR stands in the place of the merchant in the event that a merchant refuses, or is unable due to bankruptcy or other reasons, to pay on charge-backs from cardholders. Management has taken certain actions to decrease the risk of merchant bankruptcy associated with its merchant credit card business. These steps include the discontinuance of high-risk accounts. Charge-back exposure can also result from fraudulent credit card transactions initiated by merchant customers. To mitigate merchant fraud risk, the Company employs certain underwriting standards when accepting a new merchant. Further, the Company monitors merchant activity for unusual transactions. In addition, the Company bears the risk of merchant nonpayment of applicable interchange, assessment and other fees. Failure by the merchants to pay such fees may adversely affect the Company's revenues. The Company utilizes ISOs to acquire merchant credit card customers. The Company's ability to maintain and grow net revenue from its merchant credit card processing operation is dependent upon maintaining and adding to these ISO relationships. This page is page 31 of 40 pages. Merchant credit card processing services are highly regulated by credit card associations such as Visa. In order to participate in the credit card programs, the Company must comply with the credit card association's rules and regulations that may change from time to time. If the Company fails to comply with these credit card association standards, the Company's status as a member service provider and as a certified processor could be suspended or terminated. During November 1999, Visa adopted several rule changes to reduce risks in high-risk merchant credit card programs and these rule changes affect the Company's merchant credit card business. The rule changes went into effect on March 31, 2001. These changes included a requirement that a processor's reported fraud ratios be no greater than three times the national average. At April 30, 2002 (the most recent period available from Visa), the Company's overall fraud ratio was less than the Visa requirement. Other Visa changes included the requirement that total processing volume in certain high-risk categories (as defined by Visa) be less than 20% of total processing volume. At June 30, 2002, the Company's total Visa transactions within these certain high-risk categories were 3.33% of total Visa processing volume. Other changes Visa announced included a requirement that weekly Visa volumes be less than 60% of an institution's tangible equity capital, as well as a requirement that aggregate charge-backs for the previous six months be less than 5% of the institution's tangible equity capital or the aggregate charge-backs for the quarter be less than .59% of the interchange count and .95% of the interchange amount. At June 30, 2002 the Company's weekly Visa volume was 50.39% of the Company's tangible equity capital, and aggregate charge-backs for the previous six months were 5.33% of tangible equity capital and the aggregate charge-backs for the quarter were .39% of the interchange count and .45% of the interchange amount. Merchant credit card participants, such as the Company, must comply with these new Visa rules by filing a compliance plan with Visa. At June 30, 2002, the Company is in compliance with all rule changes that went into effect on March 31, 2001, based on Visa's acceptance of the Company's compliance plan. Should the Company be unable to comply with these rule changes, Visa will require collateral of one to four times the shortfall. Concentration of Lending Activities. Concentration of the Company's lending activities in the real estate sector, including construction loans, could have the effect of intensifying the impact on the Company of adverse changes in the real estate market in the Company's lending areas. At June 30, 2002, approximately 77% of the Company's loans were secured by real estate, of which 51% were secured by commercial real estate, including small office buildings, owner-user office/warehouses, mixed use residential and commercial properties and retail properties. Substantially all of the properties that secure the Company's present loans are located in Northern and Central California. The ability of the Company to continue to originate mortgage or construction loans may be impaired by adverse changes in local or regional economic conditions, adverse changes in the real estate market, increasing interest rates, or acts of nature (including earthquakes, which may cause uninsured damage and other loss of value to real estate that secures the Company's loans). In addition, prolonged electrical power shortages or increases in energy costs in Northern California may cause adverse changes in the Company's local economy. Due to the concentration of the Company's real estate collateral, such events could have a significant adverse impact on the value of such collateral and the Company's earnings. This page is page 32 of 40 pages. Events of September 11. The terrorist attacks on the World Trade Center and the Pentagon on September 11, 2001, have resulted in increased uncertainty regarding the economic outlook. Past experience suggests that shocks to American society of far less severity have resulted in a temporary loss of consumer and business confidence and a reduction in the rate of economic growth. It is not possible at this time to project the ultimate economic impact of these events. However, any deterioration in either the U.S. or the California economy could adversely affect the Company's financial condition and results of operations. California Energy Crisis. Due to problems associated with the deregulation of the electrical power industry in California, California utilities and other energy industry participants have experienced difficulties with the supply and price of electricity and natural gas. As a consequence of this situation, a major California public utility in the gas and power business became the subject of a voluntary bankruptcy proceeding. The California energy situation continues to be fluid and subject to many uncertainties and a number of lawsuits and regulatory proceedings have been commenced concerning various aspects of the current energy situation. Although the situation has stabilized recently, customers of the utilities were faced at times in 2001 with increased gas and electric prices, power shortages and, in some cases, rolling blackouts. The long-term impact of the energy crisis in California on the Company's markets and business cannot be predicted, but could result in an economic slow-down. This could have an adverse effect on the demand for new loans, the ability of borrowers to repay outstanding loans, the value of real estate and other collateral securing loans and, as a result, on the Company's financial condition and results or operations. Government Regulation. The Company and its subsidiaries are subject to extensive federal and state governmental supervision, regulation and control. Future legislation and government policy could adversely affect the financial industry. Although the full impact of such legislation and regulation cannot be predicted, future changes may alter the structure of, and competitive relationship among, financial institutions. Competition from Other Financial Institutions. The Company competes for deposits and loans principally with major commercial banks, other independent banks, savings and loan associations, savings banks, thrift and loan associations, credit unions, mortgage companies, insurance companies and other lending institutions. With respect to deposits, additional significant competition arises from corporate and governmental debt securities, as well as money market mutual funds. The Company also depends for its origination of mortgage loans on independent mortgage brokers who are not contractually obligated to do business with the Company and are regularly solicited by the Company's competitors. Aggressive policies of such competitors have in the past resulted, and may in the future result, in a decrease in the Company's volume of mortgage loan originations and/or a decrease in the profitability of such originations, especially during periods of declining mortgage loan origination volumes. Several of the nation's largest savings and loan associations and commercial banks have a significant number of branch offices in the areas in which the Company conducts operations. Among the advantages possessed by the larger of these institutions are their ability to make larger loans, finance extensive advertising campaigns, access international money markets and generally allocate their investment assets to regions of highest yield and demand. This page is page 33 of 40 pages. In addition, the market in which the Company competes for merchant credit card processing is intensely competitive and, in recent years, has been characterized by increased consolidation. This consolidation has enabled certain of the Company's competitors to have access to significant capital, management, marketing and technological resources that are equal to or greater than those of the Company, and there can be no assurance that the Company will be able to continue to compete successfully with such other processors. Critical Accounting Policies. The Company's financial statements are presented in accordance with accounting principles generally accepted in the United States of America (US GAAP). The financial information contained within our financial 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. A variety of factors could affect the ultimate value that is obtained either when earning income, recognizing an expense, recovering an asset or relieving a liability. Along with other factors, we use historical loss factors to determine the inherent loss that may be present in our loan and lease portfolio. Actual losses could differ significantly from the historical loss factors that we use. Other estimates that we use are fair value of our securities and expected useful lives of our depreciable assets. We have not entered into derivative contracts for our customers or for ourselves, which relate to interest rate, credit, equity, commodity, energy, or weather-related indices. US GAAP itself may change from one previously acceptable method to another method. Although the economics of our transactions would be the same, the timing of events that would impact our transactions could change. Our most significant estimates are approved by our Management team, which is comprised of our most senior officers. At each financial reporting period, a review of these estimates is then presented to our Board of Directors. As of June 30, 2002, other than previously disclosed on page 27, we have not created any special purpose entities to securitize assets or to obtain off-balance sheet funding. Although we have sold a number of loans in the past two years, those loans have been sold to third parties without recourse, subject to customary representations and warranties. Impact of New Accounting Standards. The Financial Accounting Standards Board (FASB) recently issued Statement of Financial Accounting Standards (SFAS) No. 145 and No. 146. SFAS No. 145 applies for years beginning after May 14, 2002 and may be adopted sooner. SFAS No. 145 covers extinguishments of debt and leases, and includes some minor technical corrections. Under previous accounting guidance, gains or losses from extinguishments of debt were always treated as extraordinary items. Under SFAS No. 145 they will no longer be considered extraordinary, except under very limited conditions. Upon adoption of SFAS No. 145, any prior gains and losses from extinguishments of debt must be reclassified as ordinary gains and losses. Under SFAS No. 145, if a capital lease is modified to become an operating lease, it will be accounted for as a sale-leaseback, by following the accounting guidance of SFAS No. 98, instead of being accounted for as a new lease. SFAS No. 146 covers accounting for costs associated with exit or long-lived asset disposal activities, such as restructurings, consolidation or closing of facilities, lease termination costs or employee relocation or severance costs. SFAS No. 146 replaces Emerging Issues Task Force (EITF) 94-3, and is to be applied prospectively to exit or disposal activities initiated after December 31, 2002, and may be adopted sooner. A company may not restate its previously issued financial statements. SFAS No. 146 requires exit or long-lived asset disposal costs to be recognized as an This page is page 34 of 40 pages. expense when the liability is incurred and can be measured at fair value, rather than at the date of making a commitment to an exit or disposal plan. Management does not expect the effects of the future adoptions of SFAS No. 145 and SFAS No. 146 to be material to the Company's consolidated financial position or results of operations. Certifications Under Section 906 of the Sarbanes-Oxley Act of 2002 The certification by the Company's chief executive officer and chief financial officer of this report on Form 10-Q, as required by section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. Section 1350), has been submitted to the Securities and Exchange Commission as additional correspondence accompanying this report. Item 3. Quantitative and Qualitative Disclosures About Market Risk As a financial institution, the Company's primary component of market risk is interest rate volatility. Fluctuation in interest rates will ultimately impact both the level of income and expense recorded on a large portion of the Bank's assets and liabilities, and the market value of all interest earning assets and interest bearing liabilities, other than those which possess a short term to maturity. Since virtually all of the Company's interest bearing liabilities and all of the Company's interest earning assets are located at the Bank (or in its wholly-owned subsidiary), virtually all of the Company's interest rate risk exposure lies at the Bank level. As a result, all significant interest rate risk management procedures are performed at the Bank level. Based upon the nature of its operations, the Bank is not subject to foreign currency exchange or commodity price risk. The Bank's real estate loan portfolio, concentrated primarily within Northern California, is subject to risks associated with the local economy. The Company does not own any trading assets. The fundamental objective of the Company's management of its assets and liabilities is to maximize the economic value of the Company while maintaining adequate liquidity and an exposure to interest rate risk deemed by management to be acceptable. Management believes an acceptable degree of exposure to interest rate risk results from the management of assets and liabilities through maturities, pricing and mix to attempt to neutralize the potential impact of changes in market interest rates. The Bank's profitability is dependent to a large extent upon its net interest income, which is the difference between its interest income on interest-earning assets, such as loans and securities, and its interest expense on interest-bearing liabilities, such as deposits and borrowings. The Bank, like other financial institutions, is subject to interest rate risk to the degree that its interest-earning assets reprice differently than its interest-bearing liabilities. The Bank manages its mix of assets and liabilities with the goals of limiting its exposure to interest rate risk, ensuring adequate liquidity, and coordinating its sources and uses of funds. This page is page 35 of 40 pages. The Bank seeks to control its interest rate risk exposure in a manner that will allow for adequate levels of earnings and capital over a range of possible interest rate environments. The Bank has adopted formal policies and practices to monitor and manage interest rate risk exposure. As part of this effort, the Bank measures risk in three ways: repricing of earning assets and interest bearing liabilities; changes in net interest income for interest rate shocks up and down 200 basis points; and changes in the market value of equity for interest rate shocks up and down 200 basis points. The following table sets forth, as of June 30, 2002, the distribution of repricing opportunities for the Company's earning assets and interest-bearing liabilities, the interest rate sensitivity gap, the cumulative interest rate sensitivity gap, the interest rate sensitivity gap ratio (i.e., earning assets divided by interest-bearing liabilities) and the cumulative interest rate sensitivity gap ratio. After Three After Six After One Within Months but Months but Year But Three Within Six Within One Within After Five Months Months Year Five Years Years Total ----------------------------------------------------------------------- (Dollars in thousands) Interest earning assets: Federal funds sold $34,863 $ --- $ --- $ --- $ --- $34,863 Investment securities and other 2,892 6,857 11,197 39,943 14,664 75,553 Mortgage loans held for sale 313 --- --- --- --- 313 Loans 108,477 51,954 40,758 124,561 32,112 357,862 ----------------------------------------------------------------------- Total interest-earning assets 146,545 58,811 51,955 164,504 46,775 468,591 ----------------------------------------------------------------------- Interest-bearing liabilities: Interest-bearing transaction accounts 120,020 --- --- --- --- 120,020 Time deposits 101,410 56,085 54,101 6,957 --- 218,553 Trust preferred securities --- --- --- --- 10,000 10,000 Short-term borrowings 5,823 --- --- --- --- 5,823 ----------------------------------------------------------------------- Total interest-bearing liabilities 227,253 56,085 54,101 6,957 10,000 354,396 ----------------------------------------------------------------------- Interest rate sensitivity gap ($80,708) $2,726 ($2,146) $157,548 $36,775 =========================================================== Cumulative interest rate sensitivity gap (80,708) (77,982) (80,128) 77,420 114,196 Interest rate sensitivity gap ratio 0.64 1.05 0.96 23.65 4.68 Cumulative interest rate sensitivity gap ratio 0.64 0.72 0.76 1.22 1.32 The Company's gap position is substantially dependent upon the volume of mortgage loans held in the portfolio. These loans generally have maturities greater than five years; however, these loans have a repricing frequency of at least quarterly and therefore are classified in the above table as repricing within three months. Additionally, interest-bearing transaction accounts, which consist of money market and savings deposit accounts, are classified as repricing within three months. Some of these deposits may be repriced at management's option, and therefore a decision not to reprice such deposits could significantly alter the Company's net interest margin. This page is page 36 of 40 pages. Management expects that, in a declining interest rate environment, the Company's net interest margin would be expected to decline, and, in an increasing interest rate environment, the Company's net interest margin would tend to increase. The Company has experienced greater mortgage lending activity through mortgage refinancings and financing new home purchases as rates declined, and may increase its net interest margins in an increasing rate environment if more traditional commercial bank lending becomes a higher percentage of the overall earning assets mix. There can be no assurance, however, that under such circumstances the Company will experience the described relationships to declining or increasing interest rates. On a quarterly basis, NBR management prepares an analysis of interest rate risk exposure. Such analysis calculates the change in net interest income and the theoretical market value of the Bank's equity given a change in general interest rates of 200 basis points up and 200 basis points down. All changes are measured in dollars and are compared to projected net interest income and the current theoretical market value of the Bank's equity. This theoretical market value of the Bank's equity is calculated by discounting cash flows associated with the Company's assets and liabilities. The following is a summary of interest rate risk exposure as of June 30, 2002 as measured on a net interest income basis and a market value of equity basis, given a change in general interest rates of up to 200 basis points up and 200 basis points down. June 30, 2002 ------------- Change in Annual Change in Change in Interest Rate Net Interest Income Market Value of Equity ----------------------- ------------------- ---------------------- +200 $616,000 ($8,050,000) +100 $390,000 ($3,771,000) -100 ($734,000) $1,157,000 -200 ($2,224,000) $1,709,000 The model utilized by management to create the report presented above makes various estimates at each level of interest rate change regarding cash flows from principal repayments on loans and mortgage-backed securities and/or call activity on investment securities. In addition, repricing these earning assets and matured liabilities can occur in one of three ways: (1) the rate of interest to be paid on an asset or liability may adjust periodically based on an index; (2) an asset, such as a mortgage loan, may amortize, permitting reinvestment of cash flows at the then-prevailing interest rates; or (3) an asset or liability may mature, at which time the proceeds can be reinvested at current market rate. Actual results could differ significantly from those estimates, which would result in significant differences in the calculated projected change. This page is page 37 of 40 pages. PART II OTHER INFORMATION Item 2. Changes in Securities and Use of Proceeds. On February 22, 2001, the Company completed its $10,000,000 participation in a pooled trust preferred securities offering. Issuance costs amounted to approximately $300,000 and are being amortized over the 30-year life of the securities. The Company, relying on Section 4(2), Rule 506 and Rule 903 of the Securities Act of 1933, as amended, sold the securities directly to Preferred Term Securities, Ltd. II, a Cayman Islands corporation. The proceeds have been, and will continue to be, used for share repurchases and general corporate purposes. Item 4. Submission of Matters to a Vote of Security Holders a) The Company held its Annual Meeting of Shareholders on May 21, 2002. b) Proxies for the Annual Meeting were solicited pursuant to Regulation 14 under the Securities Exchange Act of 1934. There was no solicitation in opposition to management's nominees for directors as listed in the Company's proxy statement for the Annual Meeting. c) The vote for the nominated directors was as follows: Nominee For Withheld ------- --- -------- John H. Brenengen 2,913,361 5,498 Dana R. Johnson 2,916,375 2,484 Patrick W. Kilkenny 2,867,594 51,265 Gregory J. Smith 2,916,116 2,743 William B. Stevenson 2,916,239 2,620 The vote for ratifying the appointment of Crowe Chizek and Company LLP as the Company's independent auditors was as follows: For 2,909,941 Against 4,781 Abstain 4,137 Broker Non-Vote 566,898 Item 6. Exhibits and Reports on Form 8-K. a) Exhibits. None This page is page 38 of 40 pages. b) Reports on Form 8-K 1. Form 8-K filing dated April 18, 2002 announcing first quarter 2002 results. 2. Form 8-K filing dated April 5, 2002 announcing declaration of quarterly dividend. This page is page 39 of 40 pages. SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. REDWOOD EMPIRE BANCORP (Registrant) Date: 8/8/02 By: /s/ James E. Beckwith ------ --------------------------------- James E. Beckwith Executive Vice President, Chief Financial Officer and Chief Operating Officer (Principal Financial Officer and Duly Authorized Officer) This page is page 40 of 40 pages.