================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31,1999 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 Incorporated 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 _ Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. May 5, 1999: 3,405,057 REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Index Page PART I. Financial Information Item 1. Financial Statements Consolidated Statements of Operations Three Months ended March 31, 1999 and 1998........................3 Consolidated Balance Sheets March 31, 1999 and December 31, 1998..............................4 Consolidated Statements of Cash Flows Three Months Ended March 31, 1999 and 1998........................5 Notes to Consolidated Financial Statements........................7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................11 Item 3. Quantitative and Qualitative Disclosure about Market Risk................................................27 PART II. Other Information Item 4. Exhibits and Reports on Item 8-K.................................31 SIGNATURES .................................................................33 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 March 31, 1999 1998 --------------------------- Interest income: Interest and fees on loans $6,609 $6,854 Interest on investment securities 956 1,126 Interest on federal funds sold 178 326 --------------------------- Total interest income 7,743 8,306 Interest expense: Interest on deposits 2,721 3,381 Interest on subordinated notes 142 277 Interest on other borrowings 53 74 --------------------------- Total interest expense 2,916 3,732 --------------------------- Net interest income 4,827 4,574 Provision for loan losses 300 510 --------------------------- Net interest income after loan loss provision 4,527 4,064 --------------------------- Noninterest income: Service charges on deposit accounts 255 274 Merchant draft processing, net 779 441 Loan servicing income 66 179 Net realized gain on sale of investment securities available for sale 14 105 Gain on sale of loans and loan servicing 704 947 Mortgage loan brokerage revenue, net 1,202 1,084 Other income 366 297 --------------------------- Total noninterest income 3,386 3,327 Noninterest expense: Salaries and employee benefits 3,420 3,003 Occupancy and equipment expense 803 809 Other 1,587 1,837 --------------------------- Total noninterest expense 5,810 5,649 --------------------------- Income before income taxes and extraordinary item 2,103 1,742 Provision for income taxes 809 635 --------------------------- Income before extraordinary item 1,294 1,107 Extraordinary item 459 --- Income tax benefit (183) --- --------------------------- Total extraordinary item, net of tax 276 --- --------------------------- Net income 1,018 1,107 Dividends on preferred stock --- 112 =========================== Net income available for common stock shareholders $1,018 $995 =========================== Earnings per common share and common equivalent share: Basic earnings per share before extraordinary item $.38 $.36 Basic earnings per share .30 .36 Diluted earnings per share before extraordinary item .37 .32 Dilute earnings per share .29 .32 See Notes to Consolidated Financial Statements. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Balance Sheets (dollars in thousands) (unaudited) March 31, December 31, 1999 1998 ------------------ ------------------ Assets: Cash and due from banks $30,306 $15,982 Federal funds sold and repos 13,144 26,205 ------------------ ------------------ Cash and cash equivalents 43,450 42,187 Investment securities: Held to maturity (market value of $35,254 and $30,014) 35,353 29,872 Available for sale, at market 32,233 30,538 ------------------ ------------------ Total investment securities 67,586 60,410 Mortgage loans held for sale 26,270 32,620 Loans: Residential real estate mortgage 110,376 97,194 Commercial real estate mortgage 69,218 59,257 Commercial 60,085 63,260 Real estate construction 43,782 46,905 Installment and other 3,516 5,095 Less deferred loan fees (1,696) (2,395) ------------------ ------------------ Total portfolio loans 285,281 269,316 Less allowance for loan losses (8,242) (8,041) ------------------ ------------------ Net loans 277,039 261,275 Premises and equipment, net 4,022 4,082 Mortgage servicing rights 245 305 Other real estate owned 1,611 2,181 Cash surrender value of life insurance 3,077 3,033 Other assets and interest receivable 10,338 16,206 ================== ================== Total assets $433,638 $422,299 ================== ================== Liabilities and Shareholders' equity: Deposits: Noninterest bearing demand deposits $94,235 $82,448 Interest-bearing transaction accounts 138,340 141,316 Time deposits $100,000 and over 63,763 62,600 Other time deposits 77,616 78,356 ------------------ ------------------ Total deposits 373,954 364,720 Other borrowings 9,847 1,371 Subordinated notes --- 12,000 Other liabilities and interest payable 10,293 5,568 ------------------ ------------------ Total liabilities 394,094 383,659 Shareholders' equity: Common stock, no par value; authorized 10,000,000 shares; issued and outstanding 3,379,656 and 3,363,565 shares 26,012 25,801 Retained earnings 13,483 12,600 Accumulated other comprehensive income, net 49 239 ------------------ ------------------ Total shareholders' equity 39,544 38,640 ------------------ ------------------ Total liabilities and shareholders' equity $433,638 $422,299 ================== ================== See Notes to Consolidated Financial Statements. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) (unaudited) Three Months Ended March 31, 1999 1998 -------------- -------------- Cash flows from operating activities: Net income $1,018 $1,107 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization, net 349 207 Net realized gains on securities available for sale (14) (105) Loans originated for sale (101,880) (92,263) Proceeds from sale of loans held for sale 108,230 87,930 Gain on sale of loans and loan servicing (704) (947) Provision for loan losses 300 510 Change in other assets and interest receivable 3,255 (140) Change in other liabilities and interest payable 7,371 (488) Other, net 16 248 -------------- -------------- Total adjustments 16,923 (5,048) -------------- -------------- Net cash provided by (used in) operating activities 17,941 (3,941) -------------- -------------- Cash flows from investing activities: Net change in loans (15,304) 12,995 Proceeds from sales of loans in portfolio --- 172 Purchases of investment securities available for sale (5,017) (11,081) Purchases of investment securities held to maturity (6,150) (4,022) Sales of investment securities available for sale --- 2,955 Maturities of investment securities available for sale 3,015 10,900 Maturities of investment securities held to maturity 647 11,229 Premises and equipment, net (289) (582) Purchase of mortgage servicing rights --- (2) Proceeds from sale of other real estate owned 786 1,071 -------------- -------------- Net cash provided by (used in) investment activities (22,312) 23,635 -------------- -------------- Cash flows from financing activities: Change in noninterest bearing transaction accounts 11,787 (6,324) Change in interest bearing transaction accounts (2,976) 5,302 Change in subordinated debt (12,000) --- Change in time deposits 423 (5,386) Change in borrowings 8,476 3,285 Issuance of stock 59 52 Dividends paid (135) (112) -------------- -------------- Net cash provided by (used) in financing activities 5,634 (3,183) -------------- -------------- Net change in cash and cash equivalents 1,263 16,511 Cash and cash equivalents at beginning of period 42,187 56,058 -------------- -------------- Cash and cash equivalents at end of period $43,450 $72,569 ============== ============== REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) (Continued) Three Months Ended March 31, 1999 1998 -------------- ------------- Supplemental Disclosures: Cash paid during the period for: Interest expense 2,910 5,261 Noncash investing and financing activities: Transfers from loans to other real estate owned 232 726 Transfer from mortgage loans held for sale to loans --- 216 Dividend declared 135 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 financial statements and related notes contained in Redwood Empire Bancorp's 1998 Annual Report to Shareholders. The statements include the accounts of Redwood Empire Bancorp ("Redwood"), and its wholly owned subsidiary, National Bank of the Redwoods ("NBR"). 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 three months ended March 31, 1999 are not necessarily indicative of the results that may be expected for the year ending December 31, 1999. 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. 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 entity. The Company's pertinent earnings per share data is as follows: Three Months Ended, March 31 1999 1998 ------------------------- ------------------------- Basic Diluted Basic Diluted ---------- ---------- ---------- ---------- Earnings per share before extraordinary item: Income before extraordinary item $1,294 $1,294 $1,107 $1,107 Less: Preferred stock dividend --- --- 112 112 ---------- ---------- ---------- ---------- Income before extraordinary item available to common stock shareholders $1,294 $1,294 $995 $995 ========== ========== ========== ========== Weighted average common shares outstanding 3,372 3,463 2,793 3,445 ========== ========== ========== ========== Earnings per share before extraordinary item $0.38 $0.37 $0.36 $0.32 ========== ========== ========== ========== Earnings per share: Net income $1,018 $1,018 $1,107 $1,107 Less: Preferred stock dividend --- --- 112 112 ---------- ---------- ---------- ---------- Net income available to common stock $1,018 $1,018 $995 $995 shareholders ========== ========== ========== ========== Weighted average common shares outstanding 3,372 3,463 2,793 3,445 ========== ========== ========== ========== Earnings per share $0.30 $0.29 $0.36 $0.32 ========== ========== ========== ========== 3. Comprehensive Income The Company's total comprehensive earnings presentation is as follows: Three Months Ended March 31, 1999 1998 --------------- ------------- Net income as reported $1,018 $1,107 Other comprehensive income (net of tax): Change in unrealized holding gain (losses) on available for sale securities (182) 44 Reclassification adjustment (8) (25) =============== ============= Total comprehensive income $828 $1,126 =============== ============= 4. Common Stock Dividend On February 16, 1999 the Board of Directors declared a quarterly cash dividend of 4 cents per share on the Company's Common Stock. The dividend is payable on April 15, 1998 to shareholders of record on March 31, 1999. 5. Extraordinary Item In the first quarter of 1999 the Company recorded an extraordinary charge of $276,000, net of tax. Such charge is comprised of the unamortized debt issuance costs associated with the Company's $12,000,000 subordinated debt, which was early redeemed in the first quarter of 1999. In the first quarter of 1999 Redwood obtained funding for the early redemption through an $8.0 million dividend from NBR and the redemption of a $3.0 million note from NBR. 6. Business Segments During the three month periods ended March 31, 1999 and 1998, the Company operated in four principal product and service lines: core community banking, merchant card services, sub prime lending, and residential mortgage banking and brokerage. The Company's core community banking industry segment includes commercial, commercial real estate, construction, and permanent residential lending along with all depository activities. The Company's merchant card services industry group provides credit card settlement services for 30,000 merchants throughout the United States. The Company's sub prime lending unit, known as Allied Diversified Credit, provides sub prime residential loans for homeowners located principally in Northern California. The Company's residential mortgage banking and brokerage arm, known as Valley Financial, includes the origination and brokerage of "A paper" loans, and servicing of loans for investors. 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 includes 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. For the three months ended March 31, 1999 ------------------------------------------------------------ Mortgage Community Banking and Total Banking Sub Prime Bankcard Brokerage Company ------------------------------------------------------------ (in thousands) Total Interest Income 7,228 121 0 394 7,743 Total Interest Expense 2,903 5 3 5 2,916 Interest income/(expense) allocation 439 (131) 137 (445) 0 ------------------------------------------------------------ Net Interest Income 4,764 (15) 134 (56) 4,827 Provision for Loan Losses 294 6 0 0 300 Total other Operating Income 547 100 779 1,960 3,386 Total other Operating Expense 3,039 329 323 2,119 5,810 ------------------------------------------------------------ Income before income taxes 1,978 (250) 590 (215) 2,103 Provision for income taxes 767 (99) 226 (85) 809 ------------------------------------------------------------ Income before extraordinary item 1,211 (151) 364 (130) 1,294 ============================================================ Total Average Assets 378,005 3,205 10,147 32,527 423,884 ============================================================ For the three months ended March 31, 1998 ------------------------------------------------------------ Mortgage Community Banking and Total Banking Sub Prime Bankcard Brokerage Company ------------------------------------------------------------ (in thousands) Total Interest Income 7,745 130 0 431 8,306 Total Interest Expense 3,708 8 8 8 3,732 Interest income/(expense) allocation 327 (85) 125 (367) 0 ------------------------------------------------------------ Net Interest Income 4,364 37 117 56 4,574 Provision for Loan Losses 504 6 0 0 510 Total other Operating Income 906 291 441 1,689 3,327 Total other Operating Expense 3,459 587 245 1,358 5,649 ------------------------------------------------------------ Income before income taxes 1,307 (265) 313 387 1,742 Provision for income taxes 475 (97) 114 143 635 ------------------------------------------------------------ Income before extraordinary item 832 (168) 199 244 1,107 ============================================================ Total Average Assets 388,383 5,517 9,482 22,262 425,644 ============================================================ 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 the Securities Act of 1933 and Securities Act of 1934. These forward-looking statements (which involve the Company's plans, beliefs and goals, refer to estimates 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: o Competitive pressure in the banking and mortgage industry and changes in the regulatory environment. o Changes in the interest rate environment and volatility of rate sensitive deposits. o The health of the economy declines 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. o Credit quality deteriorates which could cause an increase in the provision for loan losses. o Risks associated with the Year 2000 which could cause disruptions in the Company's operations or increase expenses. o Losses in the Company's merchant credit card processing business. o Asset/liability matching risks and liquidity risks. o Changes in the securities markets. 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, 1998 and Certain Important Considerations for Investors. The following sections discuss significant changes and trends in financial condition, capital resources and liquidity of the Company from December 31, 1998 to March 31, 1999, and significant changes and trends in the Company's results of operations for the three months ended March 31, 1999, compared to the same period in 1998. Summary of Financial Results The Company reported income before extraordinary item of $1,294,000 or $.37 per diluted share and net income of $1,018,000 or $.29 per diluted share for the three months ended March 31, 1999, as compared to $1,107,000 ($.32 per diluted share) for the same period in 1998. The extraordinary item relates to the unamortized debt issuance costs, net of tax, associated with the Company's $12,000,000 subordinated debt. Such debt was redeemed in the first quarter of 1999. The increase in income before extraordinary item for the first quarter in 1999 when compared to the same period one year ago is due to an increase of $253,000 in net interest income, an increase of $59,000 in non interest income, and an increase of $161,000 in non interest expense. Net Interest Income Net interest income increased from $4,574,000 during the first quarter of 1998 to $4,827,000 in the first quarter of 1999 which represents an increase of $253,000 or 5.50%. Such increase is primarily due to an increase in the net interest margin from 4.73% to 5.00%. Yield on earning assets decreased from 8.58% to 8.02% primarily due to a decrease in general interest rates as evidenced by a decline in the prime rate from 8.50% in 1998 to 7.75% in 1999. Yield paid on interest bearing liabilities also declined as such yield amounted to 4.91% in the first quarter of 1998 as compared to 4.07% in the same period in 1999. This decline is attributable to a decline in the general interest rate environment and the Company's downward repricing of the rates paid on money market accounts in mid 1998. Average earning assets declined slightly in the first quarter of 1999 when compared to the same period one year ago. Average earning assets amounted to $386,226,000 during the three month period ended March 31, 1999 as compared to $387,101,000 in 1998. The decline in average earning assets during the first three months of 1999 when compared to 1998 is primarily due to a decline in federal funds sold partially offset by an increase in average mortgage loans held for sale. Further contributing to the improvement in the Company's net interest margin was a change in the Company's funding mix. Total average interest bearing liabilities declined from $303,867,000 in the first quarter of 1998 to $286,888,000 in the same period in 1999 which represents an decrease of $16,979,000. This decrease was partially offset by an increase in average noninterest bearing transaction accounts of $7,373,000. The following is an analysis of the net interest margin: Three months ended Three months ended March 31, 1999 March 31, 1998 Average % Average % (dollars in thousands) Balance Interest Yield Balance Interest Yield ---------------------------------------- ---------------------------------------- Earning assets (1) $386,226 $7,743 8.02 $387,101 $8,306 8.58 Interest-bearing liabilities 286,888 2,916 4.07 303,867 3,732 4.91 ------------- -------------- Net interest income $4,827 $4,574 ============= ============== Net interest income to earning assets 5.00 4.73 (1) Nonaccrual loans are included in the calculation of the average balance of earning assets, and interest not accrued is excluded. 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 months ended March 31, 1999 and 1998. Changes not solely attributable to rate or volume have been allocated to rate. Three months ended March 31, 1999 over March 31, 1998 Volume Rate Total --------------------------------------------------- (in thousands) Increase (decrease) in interest income: Portfolio loans $50 ($248) ($198) Mortgage loans held for sale 169 (216) (47) Investment securities (63) (107) (170) Federal funds sold (112) (36) (148) --------------------------------------------------- Total increase (decrease) 44 (607) (563) --------------------------------------------------- Increase (decrease) in interest expense: Interest-bearing transaction accounts (142) (382) (524) Time deposits 9 (145) (136) Other borrowings (79) (77) (156) --------------------------------------------------- Total increase (decrease) (212) (604) (816) --------------------------------------------------- Increase in net interest income $256 ($3) $253 =================================================== Provision for Loan Losses The provision for loan losses for the three months ended March 31, 1999 amounted to $300,000 as compared to $510,000 in the same quarter in the previous year. For further discussion see Allowance for Loan Losses. Other Operating Income and Expense and Income Taxes Other Operating Income The following table sets forth the components of the Company's other operating income for the three months ended March 31, 1999, as compared to the same period in 1998. Three Months Ended March 31, --------------------------- (dollars in thousands) 1999 1998 ----------- ----------- Service charges on deposit accounts 255 274 Merchant draft processing, net 779 441 Loan servicing income 66 179 Gain (loss) on securities 14 105 Gain on sale of loans and servicing 704 947 Mortgage brokerage revenue, net 1,202 1,084 Other income 366 297 ----------- ----------- Total other operating income $3,386 $3,327 =========== =========== Other operating income increased $59,000 or 2% to $3,386,000 for the first quarter of 1999 when compared to $3,327,000 for the same period in 1998. Such increase is primarily due to an increase of $118,000 in net mortgage loan brokerage revenue, an increase of $338,000 in merchant card net revenue offset by a decrease of $243,000 in gain on sale of loans and servicing. Gain on sale revenue is derived from the sale of both sub prime mortgage loans the Company originates and "A" paper mortgage loans originated within the Company's mortgage loan division, Valley Financial. Other Operating Expense Other operating expense increased by $161,000 or 3% to $5,810,000 during the first quarter of 1999 compared to $5,649,000 for the first quarter of 1998, primarily due to an increase in salaries and benefits to accommodate a build up in mortgage brokerage and mortgage banking infrastructure. The following table sets forth the components of the Company's other operating expense during the three months ended March 31, 1999, as compared to the same period in 1998. Three Months Ended March 31, -------------------------- (dollars in thousands) 1999 1998 ------------- ----------- Salaries and employee benefits $3,420 $3,003 Occupancy and equipment expense 803 809 Other 1,587 1,837 ------------- ----------- Total other operating expense $5,810 $5,649 ============= =========== 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 rate was 38.5% for the three months ended March 31, 1999, compared to 36.5% for the same period in 1998. Business Segments Summary financial data by industry segment as follows: For the Three Months Ended March 31, (in thousands) ---------------------- 1999 1998 ----------- ---------- Community Banking: Revenue 5,311 5,270 Expenses 3,333 3,963 ----------- ---------- Income (loss) before income tax 1,978 1,307 =========== ========== Sub Prime: Revenue 85 328 Expenses 335 593 ----------- ---------- Income (loss) before income tax (250) (265) =========== ========== Bankcard: Revenue 913 558 Expenses 323 245 ----------- ---------- Income (loss) before income tax 590 313 =========== ========== Mortgage Banking and Brokerage: Revenue 1,904 1,745 Expenses 2,119 1,358 ----------- ---------- Income (loss) before income tax (215) 387 =========== ========== Total Company: Revenue 8,213 7,901 Expenses 6,110 6,159 ----------- ---------- Income (loss) before income tax 2,103 1,742 ========== ========== Community Banking The Community Banking segment income before income tax increased in the first quarter of 1999 when compared to the same period in the prior year. The increase is due to an improvement in the net interest margin and reduced overhead, principally OREO disposition costs and administrative expenses. Additionally the Company expects to moderately increase all categories of permanent loans within the group through renewed marketing efforts and development of new distribution channels. Sub Prime Lending In the first quarter of 1999 the Company's sub prime lending segment which is known as Allied Diversified Credit, or "ADC" recorded an operating loss of $250,000 compared to an operating loss of $252,000 in 1998. The sub prime mortgage banking business has undergone substantial changes in the last two years as increased competition, narrowing margins, and deterioration of the secondary marketing environment has caused several well publicized bankruptcies of major sub prime conduits. In response to these conditions the Company significantly downsized it's sub prime operations in the fourth quarter of 1998. The Company is currently evaluating all aspects of this business line. Bankcard The Merchant Card processing segment has experienced three successive years of revenue and earnings growth due to an increase in the number of merchants it services and an increased reliance on independent sales organizations (ISO's) to market its services. First quarter of 1999 revenue was up $338,000 or 77% over the same period in 1998. In December 1998 the Company renegotiated the terms of a processing contract with an ISO who represented $1,736,000 or 66% of the Company's 1998 merchant draft net processing revenue. In summary, as a result of the renegotiation the ISO bought down its processing rate in consideration for a payment of $2,600,000 to the Company. The term of the renegotiated contract is for two years and requires the Company to continue to process merchant card transaction volume from this ISO's customers. The Company will amortize such payment over the life of the renegotiated contract into income. The Company expects to build its overall merchant card processing business in an effort to offset any potential decline in future revenues that may result in periods following the term of the buydown. Mortgage Banking and Brokerage The Residential Mortgage Banking and Brokerage segment of the company has operated under the name "Valley Financial" since the beginning of 1997. The segment performance in the first quarter of 1999 was hindered by a rise in mortgage loan interest rates. This segment is highly sensitive to changes in mortgage interest rates and local economic conditions. Investment Securities Total investment securities increased $7,176,000 or 12% to $67,586,000 as of March 31, 1999 when compared to $60,410,000 as of December 31, 1998. Such increase is due to an effort to increase the overall yield in earning assets of the Company by decreasing it's overnight fed fund investment position and redeploying such amounts into the higher yielding investment portfolio. The Company's average federal fund position amounted to $8,435,000 in the first quarter of 1999 as compared to $22,264,000 in 1998. Loans Total loans increased $15,965,000 or 6% to $285,281,000 at March 31, 1999 compared to $269,316,000 at December 31, 1998. The increase in portfolio loans is primarily attributable to the Company's marketing efforts and a general expansion of businesses within the Company's market area. In addition, the Company has emphasized the funding of permanent residential real estate loans and commercial real estate loans in the first quarter of 1999. The following table summarizes the composition of the loan portfolio at March 31, 1999 and December 31, 1998. March 31, 1999 December 31, 1998 ------------------------------------ ------------------------------------ (dollars in thousands) Amount % Amount % ------------------------------------ ------------------------------------ Residential real estate mortgage $110,376 40% $97,194 36% Commercial real estate mortgage 69,218 24 59,257 22 Commercial 60,085 21 63,260 23 Real estate construction 43,782 15 46,905 18 Installment and other 3,516 1 5,095 2 Less deferred loan fees (1,696) (1) (2,395) (1) ------------------------------------ ------------------------------------ Total portfolio loans 285,281 100% 269,316 100% ================== ================== Less allowance for loan losses (8,242) (8,041) ----------------- ------------------ Net loans $277,039 $261,275 ================== ================== 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 adequacy of 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 or potential problem loans. The specific allocations are increased or decreased through management's reevaluation 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 and general economic conditions and other qualitative factors. The following table summarizes the Company's allowance for loan losses: Three months ended March 31 --------------------------- (dollars in thousands) 1999 1998 ----------- ------------- Beginning allowance for loan losses $8,041 $7,645 Provision for loan losses 300 510 Charge-offs (257) (537) Recoveries 158 31 ----------- ------------- Ending allowance for loan losses $8,242 $7,649 =========== ============= Net charge-offs to average loans (annualized) .13% .68% The allowance for loan losses as a percentage of portfolio loans decreased from 2.99% at December 31, 1998 to 2.89% at March 31, 1999. The decrease in this percentage is due to a $15,965,000 increase in the Company's total loan portfolio. Nonperforming Assets The following table summarizes the Company's nonperforming assets. March 31, December 31, (dollars in thousands) 1999 1998 -------------- --------------- Nonaccrual loans $6,831 $5,556 Accruing loans past due 90 days or more 151 --- Restructured loans 1,045 1,045 -------------- --------------- Total nonperforming loans 8,027 6,601 Other real estate owned 1,611 2,181 Other assets owned 82 129 -------------- --------------- Total nonperforming assets $9,720 $8,911 ============== =============== Nonperforming assets to total assets 2.24% 2.11% Nonperforming assets have increased from $8,911,000 as of December 31, 1998 to $9,720,000 as of March 31, 1999. The principal reasons for this decrease relate to an increase in nonaccrual loans of $1,275,000, a decrease in other real estate owned of $570,000 and an increase in accruing loans past due 90 days or more of $151,000. Nonperforming loans consist of loans to 34 borrowers, 19 of which have balances in excess of $100,000. The two largest have recorded balances of $1,127,000 and $827,000, both secured by real estate. 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. Other real estate owned consists of ten properties. Five properties are residential, two construction lots and the remaining are undeveloped acres and commercial buildings . Other assets owned included contract receivable rights and repossessed personal property carried at $82,000. Although the volume of nonperforming assets will depend in part on the future economic environment, there are also six loan relationships which total approximately $2,226,000 about which management has serious doubts as to the ability of the borrowers to comply with the present repayment terms and which may become nonperforming assets based on the information presently known about possible credit problems of the borrower. In the first three months of 1999 the Company was required by a mortgage loan investor to repurchase a residential mortgage loan in the amount of $69,000. From time to time the Company may be required to repurchase mortgage loans from investors depending upon representations and warranties of the purchase agreement between the investor and the Company. Such representations and warranties include valid appraisal, status of borrower, first payment default or fraud. Primarily these repurchases involve loans which are in default. The Company expects that it may be required to repurchase loans in the future. The Company maintains a reserve for its estimate of potential losses associated with the repurchase of previously sold mortgage loans. Such reserve amounts to $163,000 as of March 31, 1999 and $172,000 as of December 31, 1998. At March 31, 1999 the Company's total recorded investment in impaired loans (as defined by SFAS 114 and 118) was $10,226,000 of which $9,739,000 relates to the recorded investment for which there is a related allowance for credit losses of $1,558,000 determined in accordance with these statements and $487,000 relates to the amount of that recorded investment for which there is no related allowance for credit losses determined in accordance with these standards. The average recorded investment in the impaired loans during the three months ended March 31, 1999 and 1998 was $10,029,000 and $11,608,000. The related amount of interest income recognized during the periods that such loans were impaired was $123,000 and $118,000 for the three month periods ended March 31, 1999 and 1998. No interest income was recognized using a cash-basis method of accounting during the period that the loans were impaired. Liquidity Redwood's primary source of liquidity is dividends from its financial institution subsidiary. Redwood's primary uses of liquidity are associated with cash payments made to the subordinated debt holders, dividend payments made to the preferred stock holders, and operating expenses of the parent. It is Redwood's general policy to retain liquidity at Redwood at a level which management believes to be consistent with the safety and soundness of the Company as a whole. As of March 31, 1999, Redwood held $1,335,000 in deposits at NBR. Prior to April 30, 1998 Redwood paid quarterly dividends of 7.8% on its preferred stock of $5,750,000. On April 30, 1998 Redwood converted its preferred stock into common, thus eliminating the preferred dividend. On May 19, 1998 Redwood reinstated its quarterly common dividend at a rate of $.04 per share. Redwood also is required to make monthly payments of interest at 8.5% on $12,000,000 of subordinated debentures issued in 1993. Payment of these obligations is dependent on dividends from NBR. 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 became undercapitalized. If NBR is restricted from paying dividends, Redwood could be unable to pay dividends to its shareholders. No assurance can be given as to the ability of NBR to pay dividends to Redwood. During the first three months of 1999, NBR declared dividends of $300,000. Management believes that at March 31, 1999, the Company's liquidity position was adequate for the operations of Redwood and its subsidiary for the foreseeable future. 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 three months ended March 31, 1999 the Company received $17,941,000 and investing activities while using $5,634,000 in financing activities and $22,312,000 in cash flows from operating. 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 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. The Company and NBR are required to maintain minimum capital ratios defined by various federal government regulatory agencies. The FRB and the OCC have each established capital guidelines, which include minimum capital requirements. The regulations impose three sets of standards: a "risk-based", "leverage" and "tangible" capital standard. 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 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 March 31, 1999 and December 31, 1998. Company NBR -------------- ------------- March 31, 1999 Total capital to risk based assets 13.25% 12.64% Tier 1 capital to risk based assets 11.98 11.37 Leverage ratio 9.12 8.60 December 31, 1998 Total capital to risk based assets 16.94 15.98 Tier 1 capital to risk based assets 11.84 13.75 Leverage ratio 8.84 10.31 NBR's capital ratios declined in the first payoff quarter of 1999 due to an $8.0 million dividend to Redwood and the early payoff of a $3.0 million note due Redwood. Such payments were necessary to provide funding of Redwood's early redemption of its $12.0 million subordinated debt. Year 2000. The "Year 2000 Problem" relates to the fact that many computer programs and equipment utilizing microprocessors only use two digits to represent a year, such as "99" to represent "1999," which means that in the year 2000 such programs/processors could incorrectly treat the year 2000 as the year 1900. The Company's business is highly dependent on technology and data processing. As a result, Bank management and the Board of Directors have made Year 2000 compliance a high priority. The issue must be recognized as a business issue, rather than simply a computer issue, because of the way its effects could ripple through the economy. The Company could be affected either directly or indirectly by the Year 2000 issue. This could happen if any of its critical computer systems or equipment containing embedded logic fail, if the local infrastructure (power, communication system, or water system) fails, if its significant vendors or third-party processors are adversely impacted, or if its borrowers or depositors are significantly impacted by their internal systems or their customers or suppliers. The Company principally relies on third-party software and processing for its mission-critical applications needs. It licenses software and/or data processing services from outside vendors for its critical functions such as mortgage lending, merchant credit card program, ATM, item processing and customer statements. The Company also is dependent on personal computers and a local area network which is supported by a Microsoft operating environment. The foregoing systems are classified by the Company as mission critical information technology ("IT") systems. The Company's business also involves non-IT products and services, some of which have embedded technology which might not be Year 2000 ready. Some non-IT products and services involve infrastructure issues such as power, communications and water, as well as elevators, ventilation and air conditioning equipment. The Company classifies power and communications as non-IT mission critical systems. The Company's third-party application software, data processing vendors, local area network and operating systems and the power and communication infrastructure provide critical support to substantially all of its business and operations. Failure to successfully complete renovation, validation and implementation of mission critical IT systems could have a material adverse effect on the operations and financial performance of the Company. Moreover, Year 2000 issues experienced by significant vendors or third-party processors or customers of the Company could negatively impact the business and operations of the Company even if its critical IT systems function satisfactorily. Due to the many variables related to the Year 2000 issue and the lack of information on Year 2000 readiness from non-IT service providers such as power and phone systems vendors, the Company cannot quantify the potential cost of problems if the Company's renovation and implementation efforts or the efforts of significant vendors or customers are not successful. State of Readiness The Company has formed a Year 2000 team comprised of senior level employees and officers who are familiar with the business and operations of the Company. The Year 2000 team has conducted a comprehensive review of the Company's IT systems to identify systems that present Year 2000 issues. The Company has developed a plan which it believes should satisfactorily resolve Year 2000 problems related to its mission-critical IT systems. The Company's Year 2000 team is also using external resources provided by outside vendors and a consultant hired to assist the Company. Many vendors and third-party processors of the Company's critical IT systems have informed the Company that their products/systems are Year 2000 compliant. The Company's merchant credit card program is dependent on a third-party processor. This processor's testing for Year 2000 compliance is onging. No alternate vendor is readily available. In the event this vendor cannot satisfactorily process credit card changes for merchants in the Bank's program, the Bank's results of operations could be adversely impacted. If initial testing for other critical IT systems is not satisfactory, the Company plans to commence taking corrective action and complete secondary testing by on or about June 30, 1999. The Company has run tests on selected components of its core processing system during 1998 with technical assistance from the vendor and an outside consultant. At the date of this report the Company believes it remains on schedule to complete initial testing of all mission-critical IT systems by June 30, 1999. Costs The Company is expensing all period costs associated with the Year 2000 issue. Management estimates that the Bank will incur approximately an additional $150,000 in Year 2000 related expenses for the identification, correction and reprogramming, and testing of systems for Year 2000 compliance in fiscal 1999. There can be no assurance that these expenses will not increase as further testing and assessment of vendor and customer readiness for the Year 2000 continues. The above cost estimates include costs for consultants, running tests, technical assistance from vendors and costs for products replaced for Year 2000 compliance. These costs exclude the cost of the Company's internal staff time. Risks Management believes it will be difficult to predict the outcome of the Year 2000 issue due to the complexity of technology and the inability to assess the impact of the Year 2000 problem on third-party processors, non-IT mission critical systems and the local, national and international economy. Management has attempted, however, to identify a most reasonably likely worst case scenario. This scenario suggests that the Year 2000 problem might negatively impact some of the Company's significant IT vendors and processors and non-IT vendors/products through the failure of the party to be prepared or the impact on them of their own vendors and customers including possible short-term power failures. Management believes that if this scenario occurs its ability to process mortgages and/or credit card charges could be temporarily delayed and earnings could be materially adversely impacted especially if a recession results. It is not possible to predict the effect of this scenario on the economic viability of its customers and the related adverse impact it may have on the Company's financial position and results of operations, including the level of the Bank's provision for possible loan losses in future periods. Further, there can be no assurance that other possible adverse scenarios will not occur. The Company presently believes that, with modifications to existing software within its control which needs to be made Year 2000 compliant and assuming representations of Year 2000 readiness from significant IT vendors, processors and customers are accurate, the Year 2000 issue should not pose significant operational risks for the Company's IT systems as so modified. However, other significant risks relating to the Year 2000 problem are that of the unknown impact of this problem on the operations of the Bank's customers, processors and vendors, the impact of catastrophic infrastructure failures such as power, communications and water on the Company's systems, the economy and future actions which banking or securities regulators may take. The Company is making efforts to ensure that its customer base is aware of the Year 2000 problem. Year 2000 correspondence has been sent to both deposit and loan customers. The Bank has amended its credit authorization documentation to include consideration regarding the Year 2000 problem. Significant customer relationships have been identified, and such customers are being contacted by the Bank's employees to determine whether they are aware of Year 2000 risks and whether they are taking preparatory actions. The Company has also attempted to contact major vendors and suppliers of non-software products and services including those where products utilize embedded technology, to determine the Year 2000 readiness of such organizations and/or the products and services which the Company purchases from such organizations. The Company is monitoring reports provided by such vendors regarding their preparations for Year 2000. This is an ongoing process, and the company intends to continue to monitor the progress of such vendors through the century date change. Federal banking regulators have responsibility for supervision and examination of banks to determine whether each institution has an effective plan for identifying, renovating, testing and implementing solutions for Year 2000 processing and coordinating Year 2000 processing capabilities with its customers, vendors and payment system partners. Examiners are also required to assess the soundness of an institution's internal controls and to identify whether further corrective action may be necessary to assure an appropriate level of attention to Year 2000 processing capabilities. Management believes it is currently in compliance with the federal bank regulatory guidelines and timetables. Contingency Plans The Company has developed contingency plans for software systems utilized by the Company, should they not successfully pass the Company's Year 2000 testing. Generally this involves the identification of an alternate vendor or expected actions the Company could take, as well as the establishment of a trigger date to implement the contingency plan. The Company is also considering the purchase of a backup generator to provide power for certain critical functions in the event of a power failure and additional cash will be on hand for potential liquidity needs. Company personnel are being trained to manually perform certain critical functions if computers fail. The Company intends to develop, in accordance with regulatory guidelines, further contingency plans to address potential business disruptions resulting from Year 2000 issues. However, this process is not expected to be substantially completed until on or about June 30, 1999. The Company's contingency plans will be subject to change throughout 1999. Certain Important Considerations for Investors Mortgage Banking and Brokerage Activity. The Company's historic results of operations has been significantly influenced by mortgage banking activity, which can fluctuate significantly, in both volume and profitability, with changes in interest rate movements. In the fourth quarter of 1996, the Company significantly curtailed its "A paper" wholesale mortgage loan production. As a result of this action, the Company's future mortgage loan production revenue and expenses will be significantly reduced from pre-1997 levels. The Company's current mortgage banking operations include both the origination and brokering of retail oriented mortgage loan production. Such mortgage loan lending activity primarily is centered in northern California. The Company's ability to maintain and grow mortgage banking and brokerage revenue depends on a favorable interest rate, economic and real estate market conditions. Merchant Credit Card Processing. The Company's profitability can be negatively impacted should one of the Company's merchant credit card customers be unable to pay on charge-backs from cardholders. Due to a contractual obligation between the Company and Visa and Mastercard, NBR stands in the place of the merchant in the event that a merchant is unable to pay on charge-backs from cardholders. Management has taken certain actions to decrease the risk of merchant bankruptcy with its merchant bankcard business. These steps include the discontinuance of high-risk accounts. The Company utilizes ISO's 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. 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 March 31, 1999, approximately 78% of the Company's loans were secured by real estate, of which 31% 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 within 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). 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 or the Company's earnings. Government Regulation. Redwood and its subsidiaries are subject to extensive federal and state governmental supervision, regulation and control, and 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. Item 3. Quantitative and Qualitative Disclosure 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, 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. See "Asset Quality". 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. 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 March 31, 1999, 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 $13,144 $ --- $ --- $ --- $ --- $13,144 Investment securities and other 2,003 1,044 13,978 22,722 27,839 67,586 Mortgage loans held for sale 26,270 --- --- 26,270 --- --- Loans 102,103 31,582 27,521 60,204 63,871 285,281 --------------------------------------------------------------------------- Total interest-earning assets 143,520 32,626 41,499 82,926 91,710 392,281 --------------------------------------------------------------------------- Interest-bearing liabilities: Interest-bearing transaction accounts 138,340 --- --- --- --- 138,340 Time deposits 40,905 41,187 42,508 16,779 --- 141,379 Short-term borrowings 9,847 --- --- --- --- 9,847 Long-term borrowings --- --- --- --- --- --- Subordinated notes --- --- --- --- --- --- --------------------------------------------------------------------------- Total interest-bearing liabilities 189,092 41,187 42,508 16,779 --- 289,566 --------------------------------------------------------------------------- Interest rate sensitivity gap ($45,572) ($8,561) ($1,009) $66,147 $91,710 =============================================================== Cumulative interest rate sensitivity gap (45,572) (54,133) (55,142) 11,005 102,715 Interest rate sensitivity gap ratio 0.76 0.79 0.98 4.94 --- Cumulative interest rate sensitivity gap ratio 0.76 0.76 0.80 1.04 1.35 The Company's gap position is substantially dependent upon the volume of mortgage loans held for sale and held in the portfolio. These loans generally have maturities greater than five years; however, mortgage loans held for sale are generally sold within 5 to 60 days of funding and therefore are classified in the above table as repricing within three months. The Company enters into commitments to sell such loans on a forward basis, usually within 30 to 60 days. The amount of loans held for sale and the amount of forward commitments can fluctuate significantly from period to period. Additionally, interest-bearing transaction accounts, which consist of money market, demand 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. Management expects that, in a declining rate environment, the Company's net interest margin would be expected to decline, and, in an increasing 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 monthly 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 March 31, 1999 summary of interest rate risk exposure as measured on a net interest income basis and a market value of equity basis, given a change in general interest rates of 200 basis points up and 200 basis points down. March 31, 1999 -------------- Change in Annual Change in Change in Interest Rate Net Interest Income Market Value of Equity +200 $1,382,000 ($1,209,000) +100 711,000 (439,000) -100 (891,000) (1,886,000) -200 (1,878,000) (4,828,000) 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. PART II. - OTHER INFORMATION Item 4. Exhibits and Reports on Form 8-K. 1. Exhibits. The following documents are included or incorporated by reference in Form 10-Q. EXHIBIT NUMBER DESCRIPTION - -------------- ----------- 3.1 Articles of Incorporation. 3.2 Amended and restated By-Laws of the Registrant, filed as Exhibit 3 to the Registrant's 1994 Annual Report on Form 10-K and by this reference incorporated herein. 10.1 Employment Agreement between National Bank of the Redwoods and Patrick W. Kilkenny, dated as of January 1, 1994, filed as Exhibit 10.7 to the Registrant's 1993 Annual Report on Form 10-K and by this reference incorporated herein. 10.2 Lease, dated August 30, 1988, between National Bank of the Redwoods and 137 Group, a general partnership, filed as Exhibit 10.1 to the Registrant's 1989 Annual Report on Form 10-K, and by this reference incorporated herein. 10.3 Lease, dated April 18, 1990, between Allied Savings Bank, F.S.B. and Stony Point West, General Partnership, filed as Exhibit 10.2 to the Registrant's 1990 Annual Report on Form 10-K, and by this reference incorporated herein. 10.4 The Registrant's 401 (k) Profit Sharing Plan, filed as Exhibit 28.1 to the Registrant's Registration Statement on Form S-8 dated June 12, 1990 (Registration No. 33-35377), and by this reference incorporated herein. 10.5 The National Bank of the Redwoods Stock Option Plan, filed as Exhibit 28.1 to the Registrant's Post-Effective Amendment No. 1 to Registration Statement on Form S-4 dated March 27, 1989 (Registration No. 33-24642), and by this reference incorporated herein. 10.6 The Registrant's Amended and Restated 1991 Stock Option Plan, filed as Exhibit 4.1 to the Registrant's Registration Statement on Form S-8 filed on July 8, 1992 (Registration No. 33-49372), and by this reference incorporated herein. 10.7 The Registrant's Executive Salary Continuation Plan, filed as Exhibit 10.9 to the Registrant's Registration Statement on Form S-2 dated December 13, 1993 (Registration No. 33-71324), and by this reference incorporated herein. 10.8 Director Retirement Plan, filed as Exhibit 10.10 to the Registrant's Registration Statement on Form S-2 dated December 13, 1993 (Registration No. 33-71324), and by this reference incorporated herein. 10.9 Chairman Retirement Agreement, dated November 30, 1993, between the Registrant and John H. Downey, Jr., filed as Exhibit 10.11 to the Registrant's Registration Statement on Form S-2 dated December 13, 1993 (Registration No. 33-71324), and by this reference incorporated herein. 10.10 Compensation Agreement between Patrick W. Kilkenny and Redwood Empire Bancorp. 10.11 Executive Severance Agreement between Patrick W. Kilkenny and Redwood Empire Bancorp. 10.12 Salary Continuation Agreement between James E. Beckwith and Redwood Empire Bancorp. 10.13 Dividend Reinvestment and Stock Purchase Plan on Form S-3 dated April 28, 1993 (Registration No. 3361750), and by this reference incorporated herein. 27. Financial Data Schedule for the period ended March 31, 1999. 2. REPORTS ON FORM 8-K Form 8-K dated February 24, 1999 announcing completion of redemption of 8 1/2% subordinated notes due 2004 and announcing quarterly cash dividend on common stock under Item 5 "Other Events". Form 8-K dated January 27, 1999 announcing fourth quarter and full year 1998 financial results. 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 and in the capacity indicated. REDWOOD EMPIRE BANCORP (Registrant) DATE: 5/13/99 BY: /s/ James E. Beckwith ------- ---------------------------------- James E. Beckwith Executive Vice President, Chief Financial Officer, Principal Financial Officer, and Principal Accounting Officer