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 September 30, 1996 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 (I.R.S. Employer incorporation or organization) Identification No.) 111 Santa Rosa Avenue, Santa Rosa, California 95404-4945 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (707) 545-9611 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. October 18, 1996: 2,746,490 This page is page 1 of 22 pages. REDWOOD EMPIRE BANCORP AND SUBSIDIARIES INDEX PAGE ---- PART I. Financial Information ITEM 1. Financial Statements Consolidated Statements of Operations Three and Nine Months ended September 30, 1996 and 1995 . . . . . . 3 Consolidated Balance Sheets September 30, 1996 and December 31, 1995. . . . . . . . . . . . . . 4 Consolidated Statements of Cash Flows Nine Months Ended September 30, 1996 and 1995 . . . . . . . . . . . 5 Notes to Consolidated Financial Statements. . . . . . . . . . . . . 7 ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations . . . . . . . . . 8 PART II. Other Information ITEM 6. Exhibits and Reports on Item 8-K . . . . . . . . . . . . . . . . . . 21 SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 2 REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Operations (dollars in thousands except per share data) (unaudited) Three Months Ended Nine Months Ended September 30, September 30, 1996 1995 1996 1995 --------- -------- --------- --------- Interest income: Interest and fees on loans $10,409 $9,794 $31,652 $31,765 Interest on investment securities 805 1,093 2,270 2,082 Interest on federal funds sold 210 406 721 1,119 Interest on time deposits due from financial institutions 39 36 152 103 --------- -------- --------- --------- Total interest income 11,463 11,329 34,795 35,069 Interest expense: Interest on deposits 4,841 5,508 15,204 17,064 Interest on subordinated notes 277 276 838 830 Interest on other borrowings 447 722 1,274 3,048 --------- -------- --------- --------- Total interest expense 5,565 6,506 17,316 20,942 --------- -------- --------- --------- Net interest income 5,898 4,823 17,479 14,127 Provision for loan losses 545 385 3,375 1,055 --------- -------- --------- --------- Net interest income after loan loss provision 5,353 4,438 14,104 13,072 --------- -------- --------- --------- Other operating income: Service charges on deposit accounts 315 290 921 843 Merchant draft processing, net 374 398 1,381 1,014 Loan servicing income 412 398 1,297 1,253 Net realized gains (losses) on sale of investment securities --- --- (8) 85 Gain on sale of loans and loan servicing 2,149 2,055 8,230 7,499 Other income 679 384 2,104 1,385 --------- -------- --------- --------- Total other operating income 3,929 3,525 13,925 12,079 --------- -------- --------- --------- Other operating expense: Salaries and employee benefits 4,331 3,327 12,941 10,396 Occupancy and equipment expense 1,396 1,345 4,115 4,067 Restructuring charge --- --- --- (392) Other 4,954 2,285 10,783 7,160 --------- -------- --------- --------- Total other operating expense 10,681 6,957 27,839 21,231 --------- -------- --------- --------- Income (loss) before income taxes (1,399) 1,006 190 3,920 Provision (benefit) for income taxes (595) 391 70 1,632 --------- -------- --------- --------- Net income (loss) (804) 615 120 2,288 Dividends on preferred stock 112 112 336 336 --------- -------- --------- --------- Net income (loss) available for common shareholders ($916) $503 ($216) $1,952 --------- -------- --------- --------- --------- -------- --------- --------- Net income (loss) per common and common equivalent share: Primary net income (loss) per share ($.33) $.19 ($.08) $.73 Weighted average shares 2,742,000 2,700,000 2,712,000 2,669,000 Fully diluted net income(loss) per share ($.33) $.19 ($.08) $.72 Weighted average shares 2,742,000 2,700,000 2,712,000 3,200,000 See Notes to Consolidated Financial Statements. 3 REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Balance Sheets (dollars in thousands) (unaudited) September 30, December 31, 1996 1995 ------------- ------------ Cash and due from banks $18,606 $24,312 Federal funds sold 12,311 9,969 Due from broker --- 20,859 ------------- ------------ Cash and cash equivalents 30,917 55,140 Interest bearing deposits due from financial institutions 312 417 Investment securities: Held to maturity (market value of $22,929 and $6,528) 22,637 6,528 Available for sale, at market 25,733 37,436 ------------- ------------ Total investment securities 48,370 43,964 Mortgage loans held for sale 81,105 62,620 Loans: Residential real estate mortgage 118,925 168,022 Commercial real estate mortgage 79,216 65,655 Commercial 65,699 63,975 Real estate construction 86,099 69,504 Installment and other 3,305 4,103 Less deferred loan fees (2,845) (3,035) ------------- ------------ Total portfolio loans 350,399 368,224 Less allowance for loan losses (6,985) (5,037) ------------- ------------ Net loans 343,414 363,187 Premises and equipment, net 5,204 6,561 Purchased mortgage servicing rights 4,205 5,970 Other real estate owned 1,844 963 Cash surrender value of life insurance 2,751 4,363 Other assets and interest receivable 16,385 14,725 ------------- ------------ Total assets $534,507 $557,910 ------------- ------------ ------------- ------------ Deposits: Noninterest bearing demand deposits $66,247 $65,602 Interest-bearing transaction accounts 155,318 129,436 Time deposits $100,000 and over 103,689 111,479 Other time deposits 121,126 151,876 ------------- ------------ Total deposits 446,380 458,393 Other borrowings 31,628 47,871 Subordinated notes 12,000 12,000 Other liabilities and interest payable 13,191 8,061 ------------- ------------ Total liabilities 503,199 526,325 ------------- ------------ ------------- ------------ Shareholders' equity: Preferred stock, no par value; authorized 2,000,000 shares; issued and outstanding 575,000 shares 5,750 5,750 Common stock, no par value; authorized 10,000,000 shares; issued and outstanding 2,746,490 and 2,679,227 shares 19,262 18,728 Retained earnings 6,750 6,967 Unrealized gain (loss) on investment securities available for sale (454) 140 ------------- ------------ Total shareholders' equity 31,308 31,585 ------------- ------------ Total liabilities and shareholders' equity $534,507 $557,910 ------------- ------------ ------------- ------------ See Notes to Consolidated Financial Statements. 4 REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) (unaudited) Nine Months Ended September 30, 1996 1995 -------------- ------------ Cash flows from operating activities: Net income $120 $2,288 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization, net 1,683 1,567 Net realized losses (gains) on securities 8 (85) Loans originated for sale (1,200,172) (502,413) Proceeds from sale of loans held for sale 1,254,807 577,054 Gain on sale of loans and loan servicing (8,230) (7,499) Provision for loan losses 3,375 1,055 Change in other assets and interest receivable 2,380 (576) Change in other liabilities and interest payable 3,890 (782) Noncash restructuring charge --- (392) Other, net (1,698) (194) -------------- ------------ Total adjustments 56,043 67,735 -------------- ------------ Net cash provided by operating activities 56,163 70,023 -------------- ------------ -------------- ------------ Cash flows from investing activities: Net change in loans (52,182) (17,714) Proceeds from sales of loans in portfolio 2,459 60,648 Purchases of investment securities available for sale (23,202) (30,515) Purchases of investment securities held to maturity (304) (20,250) Sales of investment securities 3,992 --- Maturities of investment securities available for sale 13,500 16,000 Maturities of investment securities held to maturity 938 10,482 Premises and equipment, net (520) (524) Purchase of mortgage servicing rights 782 (101) Change in interest bearing deposits due from financial institutions 105 99 Proceeds from sale of other real estate owned 2,148 1,053 -------------- ------------ Net cash provided by (used in) investment activities (52,284) 19,178 -------------- ------------ Cash flows from financing activities: Change in noninterest bearing transaction accounts 631 11,112 Change in interest bearing transaction accounts 25,895 (6,706) Change in time deposits (38,539) (3,853) Change in borrowings (16,243) (96,133) Issuance of stock 490 78 Dividends paid (336) (336) -------------- ------------ Net cash used in financing activities (28,102) (95,838) -------------- ------------ Net change in cash and cash equivalents (24,223) (6,637) Cash and cash equivalents at beginning of period 55,140 33,354 -------------- ------------ Cash and cash equivalents at end of period $30,917 $26,717 -------------- ------------ -------------- ------------ (Continued) 5 REDWOOD EMPIRE BANCORP AND SUBSIDIARIES Consolidated Statements of Cash Flows (in thousands) (Continued) Nine Months Ended September 30, 1996 1995 --------- -------- Supplemental Disclosures: Cash paid during the period for: Income taxes $2,730 $2,620 Interest expense 17,719 20,879 Noncash investing and financing activities: Transfers from loans to other real estate owned 1,643 2,434 Loans to facilitate sale of other real estate owned --- 304 Transfer from loans to mortgage loans held for sale 50,000 12,450 Transfer from mortgage loans held for sale to loans --- 15,000 Transfer of investment securities from available for sale to held to maturity 17,193 --- 6 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 1995 Annual Report to shareholders. The statements include the accounts of Redwood Empire Bancorp and its wholly owned subsidiaries, National Bank of the Redwoods ("NBR") and Allied Bank, F.S.B. ("Allied"). All significant intercompany 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 nine months ended September 30, 1996 are not necessarily indicative of the results that may be expected for the year ending December 31, 1996. 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 and federal funds sold. Federal funds sold are generally for one day periods. 2. Net Income (loss) per Share Net income (loss) per share is calculated based on the weighted average number of shares of common stock outstanding and common stock equivalents outstanding during the three and nine month periods ended September 30, 1996 and 1995. 3. New Accounting Pronouncement On January 1, 1996, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 123 "Accounting for Stock-Based Compensation." This statement requires expanded disclosures with respect to stock-based compensation such as stock options. It also encourages, but does not require, recognition of compensation expense related to the fair value of such stock-based compensation. The Company has decided not to record compensation expense for its stock-based compensation which currently consists only of stock options. 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Redwood Empire Bancorp ("Redwood," and with its subsidiaries, the "Company") is a financial institutions holding company headquartered in Santa Rosa, California. Redwood has two principal subsidiaries, Allied Bank, F.S.B., a federal savings bank ("Allied"), and National Bank of the Redwoods, a national bank ("NBR"). The following sections discuss significant changes and trends in financial condition, capital resources and liquidity of the Company from December 31, 1995 to September 30, 1996, and significant changes and trends in the Company's results of operations for the three and nine months ended September 30, 1996, compared to the same periods in 1995. In an effort to increase shareholder value the Board of Directors is currently evaluating strategic options relating to Allied. These options include a merger of Allied into NBR or a sale or partial sale of Allied. No final determination has been made by the Board of Directors regarding the status of Allied stemming from this evaluation process. SUMMARY OF FINANCIAL RESULTS The Company reported a net loss of $804,000 (a loss of $.33 per share, fully diluted) for the three months ended September 30, 1996, compared to net income $615,000 ($.19 per share, fully diluted) for the same period in 1995. The decrease in net income in the third quarter of 1996 over the same period in 1995 is primarily due to the accrual of $2,241,000 ($1,300,000 after-tax) for the Savings Association Insurance Fund (SAIF) assessment enacted by Congress on September 30, 1996. The SAIF assessment was calculated based on 67.5 basis points on Allied's deposits as of March 31, 1995. Net income for the nine months ended September 30, 1996 was $120,000 (a loss of $.08 per share, fully diluted) compared to $2,288,000 ($.72 per share, fully diluted) for the same period in 1995. This decrease was due to the SAIF assessment, an increase in the provision for loan losses of $2,320,000 and a $1,200,000 merchant bankcard reserve recorded in the second quarter of 1996 in response to the bankruptcy of one customer for whom the Company processes credit card transactions. During the quarter and nine months ended September 30, 1996, the Company originated $337,000,000 and $1,243,000,000 in wholesale residential real estate loans or "A" paper loans within its mortgage banking operations. Due to the low profit margins and the competitive nature of the "A" paper wholesale loan business, the Company has enacted strategies which are oriented to demphasize its "A" paper wholesale mortgage banking business. Therefore, it is anticipated that mortgage loan origination volumes and expenses associated with this origination activity will be reduced significantly in the future. 8 NET INTEREST INCOME Net interest income amounted to $5,898,000 for the third quarter of 1996 which resulted in an increase of $1,075,000 when compared to the third quarter of 1995 total of $4,823,000. This increase is primarily due to the substantial growth in the net interest margin offset by a slight decline in earning assets. The net interest margin amounted to 4.76% in the third quarter of 1996 as compared to 3.81% in the same period one year ago. The net interest margin improvement was due to increased yields on earning assets from 8.95% in the third quarter of 1995 to 9.25% in the same quarter in 1996 and a reduction in funding rates from 5.64% in 1995 to 5.21% in 1996. Earning assets declined from $506,561,000 in the third quarter of 1995 to $495,706,000 in the same period in 1996 which represents a $9,855,000 decline. Net interest income for the nine months ended September 30, 1996 amounted to $17,479,000, which represented an increase of $3,352,000 when compared to the 1995 nine month total of $14,127,000. As was the case in the third quarter, the increase of $3,352,000 is primarily attributable to an increase in the net interest margin being offset by a decline in earning assets. The net interest margin for the nine months ended September 30, 1996 was 4.64% compared to 3.46% for the same period in 1995. The net interest margin improvement was driven by an increase in the yield on earning assets from 8.59% in the nine months ended September 30, 1995 to 9.23% for the same period in 1996, and a decline in funding rates from 5.60% in the nine months ended in 1995 to 5.28% in the same period in 1996. Earning assets declined $41,391,000 from the nine month period in 1995 when compared to 1996 as the Company reduced its asset size to improve its overall capital ratios. 9 The following is an analysis of the net interest margin: Three months ended Three months ended September 30, 1996 September 30, 1995 Average % Average % (dollars in thousands) Balance Interest Yield Balance Interest Yield ------------------------------------- ----------------------------------- Earning assets(1) $495,706 $11,463 9.25 $506,561 $11,329 8.95 Interest-bearing liabilities 427,128 5,565 5.21 461,264 6,506 5.64 -------- --------- Net interest income $5,898 $4,823 -------- --------- -------- --------- Net interest income to earning assets 4.76 3.81 Nine months ended Nine months ended September 30, 1996 September 30, 1995 ------------------------------------- -------------------------------------- Average % Average % (dollars in thousands) Balance Interest Yield Balance Interest Yield ------------------------------------- -------------------------------------- Earning assets (1) $502,756 $34,795 9.23 $544,147 $35,069 8.59 Interest-bearing liabilities 437,072 17,316 5.28 498,948 20,942 5.60 -------- -------- Net interest income $17,479 $14,127 -------- -------- -------- -------- Net interest income to earning assets 4.64 3.46 (1) Nonaccrual loans are included in the calculation of the average balance of earning assets, and interest not accrued is excluded. 10 The following table sets forth changes in interest income and interest expense for each major category of interest-earning assets and interest- bearing liabilities, and the amount of change attributable to volume and rate changes for the nine months ended September 30, 1996 and 1995. Changes not solely attributable to rate or volume have been allocated to rate. September 30, 1996 over September 30, 1995 --------------------------------- Volume Rate Total --------------------------------- (in thousands) Increase (decrease) in interest income: Portfolio loans ($3,798) $2,146 ($1,652) Mortgage loans held for sale 613 926 1,539 Investment securities 171 17 188 Interest-earning deposits with other institutions 29 20 49 Federal funds sold (344) (54) (398) ---------------------------------- Total increase (decrease) (3,329) 3,055 (274) ---------------------------------- Increase (decrease) in interest expense: Interest-bearing transaction accounts 930 426 1,356 Time deposits (2,905) (312) (3,217) Other borrowings (1,635) (130) (1,765) ---------------------------------- Total increase (decrease) (3,610) (16) (3,626) ---------------------------------- Increase in net interest income $281 $3,071 $3,352 ---------------------------------- ---------------------------------- PROVISION FOR LOAN LOSSES The provision for loan losses for the three months ended September 30, 1996 amounted to $545,000 as compared to $385,000 in the same quarter in the previous year. The increase in the quarterly provision of $160,000 is due to an increase in problem assets, principally nonaccrual residential construction loans. The provision for loan losses for the nine months ended September 30, 1996 amounted to $3,375,000 as compared to $1,055,000 for the same period one year ago. The increase in the provision for loan losses for the comparable nine month period relates to an increase in loan charge-offs and a lease portfolio of $1,412,000 placed on nonaccrual status. For further discussion on credit quality and provision for loan losses see "ALLOWANCE FOR LOAN LOSSES" and "NON PERFORMING ASSETS". 11 OTHER OPERATING INCOME AND EXPENSE Other Operating Income The following table sets forth the components of the Company's other operating income for the three and nine months ended September 30, 1996, as compared to the same periods in 1995. Three Months Ended Nine Months Ended September 30 % September 30 % --------------------- --------------------- (dollars in thousands) 1996 1995 Change 1996 1995 Change ---------- ----------------------- ---------- ----------------------- Service charges on deposit accounts $ 315 $ 290 9 $ 921 $ 843 9 Merchant draft processing, net 374 398 (6) 1,381 1,014 36 Loan servicing income 412 398 4 1,297 1,253 4 Gain (loss) on securities --- --- --- (8) 85 (109) Gain on sale of loans and servicing 2,149 2,055 5 8,230 7,499 10 Other income 679 384 77 2,104 1,385 52 ------ ------ -------- --------- Total other operating income $3,929 $3,525 11 $13,925 $12,079 15 ------ ------ -------- --------- ------ ------ -------- --------- Other operating income increased $404,000 or 11% to $3,929,000 for the third quarter of 1996 compared to $3,525,000 for the same period in 1995, due primarily to an increase in gain on sale of loans and servicing of $94,000 and increases in other income of $295,000. The increase in other income principally relates to miscellaneous fee income associated with the Company's mortgage banking business. Other operating income increased $1,846,000 for the nine months ended September 30, 1996 compared to the same period in 1995. This increase was primarily due to gains on sale of loans and servicing, merchant draft processing, and other income. Mortgage banking originations increased from $306 million for the third quarter of 1995 to $355 million for the third quarter of 1996. For the nine months ended September 30, 1996 mortgage banking originations amounted to $1.3 billion as compared to $557 million in the same period one year ago. However, gain on sale of loans and servicing has not kept pace with the increase in origination volume due to pricing pressure brought about by an extremely competitive mortgage banking environment. The increase in other income principally relates to miscellaneous fee income associated with the Company's mortgage banking business. 12 Other Operating Expense Other operating expense increased to $10,681,000 during the third quarter of 1996 compared to $6,957,000 for the third quarter of 1995. The increase is due primarily to the $2,241,000 SAIF assessment. In addition, an increase in salary and benefits of $1,004,000 was associated with increased mortgage banking activity at the Allied subsidiary Other operating expense increased $6,608,000 for the nine months ended September 30, 1996 compared to the same period in 1995. The increase is primarily due to the SAIF charge, increased salaries and benefits expense caused by increased loan volumes at Allied, and the recording of a merchant bankcard reserve of $1,200,000 in the second quarter of 1996 related to the bankruptcy of one customer. The merchant bankcard matter and its related $1,2000,000 charge to operations was a result of contractual obligation between NBR and Visa and Mastercard which requires that NBR stand in the place of the merchant in the event that a merchant is unable to pay on charge-backs from cardholders. In this instance, one of NBR's significant merchant bankcard customers who is in the travel business, filed for bankruptcy and was unable to pay cardholder chargebacks. The Company has undertaken certain actions to decrease the risk of merchant bankruptcy within its merchang bankcard business. These steps include elimination of all merchants in the travel business as customers and the discontinuance of any other high risk account. Management believes it has adequately provided for potential charge-backs associated with its merchant bankcard processing business. The following table sets forth the components of the Company's other operating expense during the three and nine months ended September 30, 1996, as compared to the same periods in 1995. Three Months Ended Nine Months Ended September 30 % September 30 % -------------------- ------------------- (dollars in thousands) 1996 1995 Change 1996 1995 Change --------- ------------------------ ---------- --------------------- Salaries and employee benefits $ 4,331 $3,327 30 $12,941 $10,396 24 Occupancy and equipment expense 1,396 1,345 4 4,115 4,067 1 Restructuring charge --- --- --- --- (392) (100) Other 4,954 2,285 117 10,783 7,160 51 ---------- -------- --------- --------- Total other operating expense $10,681 $6,957 54 $27,839 $21,231 31 ---------- -------- --------- --------- ---------- -------- --------- --------- NBR and Allied maintain insurance on their customer deposits with the Federal Deposit Insurance Corporation ("FDIC"). The FDIC manages the Bank Insurance Fund ("BIF"), which insures deposits of commercial banks such as NBR, and the Savings Association Insurance Fund ("SAIF"), which insures deposits of savings associations such as Allied. FDICIA mandated that the two funds maintain reserves at 1.25% of their respective federally insured deposits. During 1995, the FDIC announced that the BIF had reached its mandated reserve level, reducing insurance premiums on BIF-insured deposits, and accordingly, deposit insurance premiums on BIF-insured deposits were reduced. On September 30, 1996 Congress passed a bill which addressed the deposit insurance premium differential between BIF and SAIF insured deposits. There is a one-time insurance premium charge attributable to SAIF-insured deposits sufficient to bring the SAIF up to its mandated reserve level, with a corresponding and immediate reduction in SAIF premiums thereafter. Based on 67.5 basis points on Allied's deposits at March 31, 1995, the resulting charge to the Company was $2,241,000. Such charge was recorded in the third quarter of 1996. 13 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 36.8% for the nine months ended September 30, 1996, compared to 41.6% for the same period in 1995. MORTGAGE LOANS HELD FOR SALE Mortgage loans held for sale increased $18,485,000 or 30% to $81,105,000 at September 30, 1996 compared to $62,620,000 at December 31, 1995. The increase was primarily due to a $50,000,000 transfer of loans from the portfolio to held for sale as of March 31, 1996, $34 million of which were sold at September 30, 1996. This transaction was made to accommodate an asset reduction strategy at Allied Bank which is intended to increase the capital ratios of Allied and the Company. The fair value of loans transferred exceeded their carrying value at the date of transfer. LOANS Total loans decreased $17,825,000 or 5% to $350,399,000 at September 30, 1996 compared to $368,224,000 at December 31, 1995. Residential real estate mortgage loans decreased $49,097,000 or 29% to $118,925,000 due to a transfer of loans to mortgage loans held for sale as part of an asset reduction strategy. The Company anticipates that there will be no future transfers of loans to the held for sale category to execute an asset reduction strategy. The following table summarizes the composition of the loan portfolio at September 30, 1996 and December 31, 1995. September 30, 1996 December 31, 1995 ------------------ ----------------- (dollars in thousands) Amount % Amount % ----------------------- ----------------------- Residential real estate mortgage $118,925 34% $168,022 46% Commercial real estate mortgage 79,216 22 65,655 18 Commercial 65,699 19 63,975 17 Real estate construction 86,099 25 69,504 19 Installment and other 3,305 1 4,103 1 Less deferred fees (2,845) (1) (3,035) (1) ----------------------- ----------------------- Total loans 350,399 100% 368,224 100% -------- -------- -------- -------- Less allowance for loan losses (6,985) (5,037) ------------ ------------ Net loans $343,414 $363,187 ------------ ------------ ------------ ------------ 14 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, general economic conditions and other qualitative factors. The following table summarizes the Company's allowance for loan losses: Three months ended Nine months ended September 30 September 30 ------------------- ------------------ (dollars in thousands) 1996 1995 1996 1995 ------------------- ------------------ Beginning allowance for loan losses $7,034 $5,978 $5,037 $5,787 Provision for loan losses 545 385 3,375 1,055 Charge-offs (630) (392) (1,532) (923) Recoveries 36 2 105 54 ------- ------ ------- ------- Ending allowance for loan losses $6,985 $5,973 $6,985 $5,973 ------- ------ ------- ------- ------- ------ ------- ------- Net charge-offs to average loans (annualized) .69% .40% .55% .29% The allowance for loan losses as a percentage of portfolio loans increased from 1.37% at December 31, 1995 to 1.99% at September 30, 1996. The increase in the provision for loan losses of $2,320,000 for the nine months ended September 30, 1996 over the same period in 1995 is primarily due to a lease portfolio of $1,412,000 purchased from a company currently in bankruptcy proceedings who retained the servicing of such portfolio ("Bennett matter") and higher levels of nonperforming assets. The increase in the provision for loan losses of $160,000 in the third quarter of 1996 when compared to the same period one year ago was driven by an increase in net charge-offs of $204,000 in the third quarter of 1996 compared to the third quarter of 1995 and an increase in nonperforming assets, principally nonaccrual residential construction loans. 15 With respect to the Bennett matter, NBR has entered into a settlement agreement with the bankruptcy trustee which calls for the Bank to receive 60% of all the cash receipts associated with such leases. The agreement is subject to approval by the United States Bankruptcy Court. The motion which requests approval is expected to be heard in mid November. Consistent with Company policy, these leases have been classified as nonperforming and placed on nonaccrual status. Management expects further information to become available on the matter in the fourth quarter of 1996. Management believes that the Company maintains an adequate allowance for loss on these leases. NONPERFORMING ASSETS The following table summarizes the Company's nonperforming assets. September 30, December, 31 (dollars in thousands) 1996 1995 ---------- ----------- Nonaccrual loans $ 8,917 $ 4,201 Accruing loans past due 90 days or more 130 92 Restructured loans 757 651 ---------- ----------- Total nonperforming loans 9,804 4,944 Other real estate owned 1,844 963 Other assets owned 704 1,249 ---------- ----------- Total nonperforming assets $12,352 $7,156 ---------- ----------- ---------- ----------- Nonperforming assets to total assets 2.31% 1.28% Nonperforming assets have increased from $7,156,000 as of December 31, 1995 to $12,352,000 as of September 30, 1996. The principal reasons for this increase relate to a $4,716,000 increase in nonaccrual loans and other real estate owned. The nonaccrual loan increase was primarily due to the Bennett Matter whose aggregate outstanding balance of $1,412,000 was placed on nonaccrual in the first quarter of 1996 and an increase in nonaccrual construction loans and residential mortgages of $2,873,000 and $502,000. Due to the Company's current emphasis on construction lending, the Company may continue to experience a higher level of nonperforming assets when compared to historic levels. Nonperforming loans consist of loans to 366 borrowers, 25 of which have balances in excess of $100,000. The two largest have recorded balances of $802,000 secured by general business assets and $780,000 secured by residential real estate. Approximately 310 of the nonperforming loans are related to a purchased portfolio of leases from a servicer who is now in bankruptcy proceedings. 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. 16 Other real estate owned consists of twelve properties. Nine properties are residential, two are commercial buildings, and one is land held for sale. Other assets owned included contract receivable rights and repossessed personal property valued at $704,000. Although the volume of nonperforming assets will depend in part on the future economic environment, there are also loans totaling $4,694,000 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. At September 30, 1996 the Company's total recorded investment in impaired loans (as defined by SFAS 114 and 118) was $10,191,000 of which $4,120,000 relates to the recorded investment for which there is a related allowance for loan losses of $1,741,000 determined in accordance with these statements and $6,071,000 relates to the amount of that recorded investment for which there is no related allowance for loan losses determined in accordance with these standards. The average recorded investment in the impaired loans during the nine months ended September 30, 1996 and September 30, 1995 was $9,714,000 and $6,793,000; the related amount of interest income recognized during the periods that such loans were impaired was $17,000 and $269,000 for the three and nine month periods ended September 30, 1996 and $35,000 and $276,000 for the same periods in 1995. 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 subsidiaries. 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 September 30, 1996, Redwood held $2,319,000 in interest-bearing deposits at its subsidiaries and a $3,000,000 subordinated note issued by NBR. 17 Beginning with the fourth quarter of 1992, Redwood has paid a quarterly dividend of $.03 per share of Common Stock. In the fourth quarter of 1993, this dividend was increased to $0.035 per share. This dividend was suspended in the fourth quarter of 1994. In addition, Redwood pays quarterly dividends of 7.8% on its preferred stock of $5,750,000 and interest at 8.5% on $12,000,000 of subordinated debentures issued in 1993. Payment of these obligations is dependent on dividends from NBR and Allied. Federal regulatory agencies have the authority to prohibit the payment of dividends by NBR and Allied to Redwood if a finding is made that such payment would constitute an unsafe or unsound practice, or if NBR or Allied became undercapitalized. If NBR or Allied are restricted from paying dividends, Redwood could be unable to pay the above obligations. No assurance can be given as to the ability of Redwood's subsidiaries to pay dividends to Redwood. In the fourth quarter of 1994, Redwood received a dividend of $200,000 from NBR and $400,000 from Allied. During 1995, NBR and Allied declared dividends of $860,000 and $227,000 respectively. During 1996, NBR and Allied declared dividends of $215,000 and $2,227,000 respectively. Management believes that at September 30, 1996 the Company's liquidity position was adequate for the operations of Redwood and its subsidiaries for the foreseeable future. Although each entity within the consolidated group manages its own liquidity, the Company's consolidated cash flows can be divided into three distinct areas; operating, investing and financing. For the nine months ended September 30, 1996 the Company received $56.2 million in cash flows from operations while using $52.3 million and $28.1 million in investment and financing activities, respectively. Although the Company experienced a decline in cash and cash equivalents of $24.2 million for the nine months ended September 30, 1996, such balance was unusually high at December 31, 1995 due to proceeds of $20.9 million from a security sale not being received prior to 1995 year end. 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 each of its subsidiaries are required to maintain minimum capital ratios defined by various federal government regulatory agencies. The FRB, the OCC and the OTS 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. 18 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 core capital ratio for Allied is based on period end assets while the leverage ratio for the Company and NBR is based on average assets for the quarter. Allied is subject to a minimum tangible capital ratio of 1.5% of adjusted total assets. It is anticipated that Allied will be subject to an OTS regulation issued in August, 1993 that added an interest rate risk component to the risk-based capital requirements of thrifts. The original effective date was to be December 31, 1993 and the regulation has been postponed several times. The effective date has now been postponed indefinitely until the OTS evaluates the effectiveness of its appeals process. Under the proposed regulation, those thrifts that have an above normal interest rate risk exposure must take a deduction from the total capital available to meet their risk-based capital requirement. This deduction will be equal to one-half of the difference between the thrift's actual measured exposure and the normal level of exposure. The actual deduction taken at any quarter end is equal to the lowest amount calculated for the three quarters prior to the reporting date. A thrift's actual measured interest risk is expressed as the change that occurs in its net portfolio value ("NPV") as a result of an immediate 200 basis point increase or decrease in interest rates (whichever results in the lower NPV) divided by the estimated economic value of its assets, as calculated in accordance with OTS instructions. An above normal decline in NPV is one that exceeds 2% of the estimated economic value of its assets. Under this regulation, Allied currently would not be required to take a deduction from capital. 19 The following table summarizes the consolidated capital ratios and the capital ratios of the principal subsidiaries at December 31, 1995 and September 30, 1996. Actual Required Amount Amount Excess Actual % ------------------------------------------------ (dollars in thousands) At September 30, 1996: COMPANY Leverage (to Average Assets) $30,108 $21,158 $8,950 5.69% Tier 1 Capital (to Risk-weighted Assets) 27,462 14,813 12,649 7.42 Total Capital (to Risk-weighted Assets) 44,087 31,438 12,649 11.91 NBR Leverage Capital (to Average Assets) 17,674 9,875 7,799 7.16 Tier 1 Capital (to Risk-weighted Assets) 17,674 7,690 9,984 9.19 Total Capital (to Risk-weighted Assets) 23,094 15,380 7,714 12.01 ALLIED Core Capital (to Total Assets) 18,205 11,236 6,969 6.48 Tier 1 Capital (to Risk-weighted Assets) 15,559 6,971 8,588 8.93 Total Capital (to Risk-weighted Assets) 17,748 13,941 3,807 10.18 Tangible Capital (to Total Assets) 18,205 4,213 13,992 6.48 At December 31, 1995: COMPANY Tier 1 Capital (to Average Assets) 29,723 23,134 6,589 5.14 Tier 1 Capital (to Risk-weighted Assets) 27,123 14,991 12,132 7.24 Total Capital (to Risk-weighted Assets) 43,780 29,981 13,799 11.68 NBR Tier 1 Capital (to Average Assets) 17,283 9,258 8,025 7.47 Tier 1 Capital (to Risk-weighted Assets) 17,283 7,349 9,934 9.41 Total Capital (to Risk-weighted Assets) 22,395 14,698 7,697 12.19 ALLIED Core Capital (to Total Assets) 19,955 12,752 7,203 6.26 Tier 1 Capital (to Risk-weighted Assets) 17,355 7,528 9,827 9.22 Total Capital (to Risk-weighted Assets) 19,713 15,056 4,657 10.47 Tangible Capital (to Total Assets) 19,955 4,782 15,173 6.26 20 PART II. - OTHER INFORMATION Item 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) EXHIBIT 11 Weighted average shares, used in the computation of per share earnings, include the common stock equivalents impact of common stock options outstanding. Primary earnings per share includes the reduction of net income by the declared Preferred Stock dividend. The impact on earnings per share assuming conversion of the Preferred Stock was reflected in the fully-dilutive computation. The computation of per share earnings is incorporated by reference in the Consolidated Statement of Operations on page 3 herein. (b) REPORTS ON FORM 8-K Form 8-K dated July 17, 1996 declaring quarterly dividend on Redwood Empire Bancorp's preferred stock of 19.5 cents per share. The dividend was payable on August 14, 1996 to shareholders of record on July 30, 1996. Form 8-K dated July 25, 1996 reporting second quarter results for period ended June 30, 1996. 21 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: 11-07-96 BY: /s/ Patrick W. Kilkenny -------- ----------------------- Patrick W. Kilkenny President and Chief Executive Officer DATE: 11-07-96 BY: /s/ James E. Beckwith -------- ---------------------------- James E. Beckwith Senior Vice President and Chief Financial Officer 22