EXHIBIT 13
Farmers & Merchants Bank
of Central California
1999
Annual
Report
Dear Shareholders:
Farmers & Merchants Bancorp's roots go back to 1916 when Farmers & Merchants
Bank was founded to provide banking services to citizens living in California's
Great Central Valley. Today the Bank maintains 18 conveniently located branch
offices serving 9 Central Valley communities from Sacramento to Modesto and
Turlock. Over the past 83 years, the Bank's Directors and Management have
consistently embraced the time tested core values adopted when Farmers &
Merchants Bank was first organized. Maximizing shareholder value, exceeding
customers' expectations, fostering employee commitment and satisfaction, and
actively supporting the communities served have been key components of the
Bank's formula for success through the years.
We are extremely pleased to announce that 1999 was the most profitable and
successful year in Farmers & Merchants Bancorp's history. Net income for 1999
totaled $9,216,000 and exceeded the prior year by 14.3%. The strong growth in
profits occurred because of a 25.6% increase in total loans outstanding, a 9.2%
rise in total deposits, and an 11.3% jump in service fee income. Throughout
1999 we focused on improving the Bank's financial fundamentals. Our emphasis on
operating leverage enabled us to hold operating expense growth well below
operating revenue growth. In 1999, we achieved a 4.3% spread between revenue
growth and expense growth which produced the strong increase in operating
income. As a result, return on equity increased 94 basis points over the prior
year.
We have imposed heightened capital management discipline throughout the company
to insure that returns on each business transaction exceed the cost of capital.
Emphasis has been placed on increasing the profitability of core businesses, as
well as lowering delivery costs. We are pleased with the operational
efficiencies and improved customer service gained from the new Loan Processing
Center and are optimistic about the economies to be derived once the new
Operations Service Center opens in March 2000. Management continues to evaluate
solutions for further leveraging the Bank's existing infrastructure. In
addition, the Common Stock Repurchase Program approved by the shareholders was
utilized throughout 1999.
In the future, Farmers & Merchants Bancorp will continue to differentiate itself
through customer convenience and the delivery of quality products and service in
a friendly and personal manner. The Bank's products and services are constantly
being reviewed to ensure that customer expectations are being satisfied. We
also remain committed to augmenting the level of volunteer and financial
assistance donated to community support organizations. Our contribution levels
were further increased in 1999. Reinvesting in the communities we serve is
essential to Farmers & Merchants Bancorp's long term success.
We greatly appreciate the Board of Directors' assistance and guidance this past
year. We are also grateful for the extraordinary effort put forth by the Bank's
employees. The Bank's strong performance in 1999 is the direct result of their
dedication, hard work, and exceptional contributions. A special thank you is
also extended to our customers. We immensely value your business and feel
privileged to be able to serve you.
As we begin the new millenium, your Board of Directors and Management remain
optimistic about Farmers & Merchants Bancorp's future and ability to
successfully meet the many challenges ahead. Our shareholders have always been
a source of strength for the Bank. We greatly appreciate your continuing
confidence and support. Please keep in mind that you can enhance your
investment by transacting all of your personal business with the Bank and by
recommending Farmers and Merchants Bank to your friends, associates and new
acquaintances.
Kent A. Steinwert Ole R. Mettler
President & Chief Executive Officer Chairman of the Board
2
Report of Management
The management of Farmers & Merchants Bancorp (the Company) and its subsidiary
has the responsibility for the preparation, integrity and reliability of the
consolidated financial statements and related financial information contained in
this annual report. The financial statements were prepared in accordance with
generally accepted accounting principles and prevailing practices of the banking
industry. Where amounts must be based on estimates and judgments, they represent
the best estimates and judgments of management.
Management has established and is responsible for maintaining an adequate
internal control structure designed to provide reasonable, but not absolute,
assurance as to the integrity and reliability of the financial statements,
safeguarding of assets against loss from unauthorized use or disposition and the
prevention and detection of fraudulent financial reporting. The internal
control structure includes: an effective financial accounting environment; a
comprehensive internal audit function; an independent audit committee of the
Board of Directors; and extensive financial and operating policies and
procedures. Management also recognizes its responsibility for fostering a
strong ethical climate which is supported by a code of conduct, appropriate
levels of management authority and responsibility, an effective corporate
organizational structure and appropriate selection and training of personnel.
The Board of Directors, primarily through its audit committee, oversees the
adequacy of the Company's internal control structure. The audit committee,
whose members are neither officers nor employees of the Company, meet
periodically with management, internal auditors and internal credit examiners to
review the functioning of each and to ensure that each is properly discharging
its responsibilities. In addition, Arthur Andersen LLP, independent auditors,
are engaged to audit the Company's financial statements.
Arthur Andersen LLP obtains and maintains an understanding of the Company's
accounting and financial controls and conducts its audit in accordance with
generally accepted auditing standards which includes such audit procedures as it
considers necessary to express the opinion in the report that follows.
Management recognizes that there are inherent limitations in the effectiveness
of any internal control structure. However, management has assessed and
believes that, as of December 31, 1999, the Company's internal control
structure, as described above, provides reasonable assurance as to the integrity
and reliability of the financial statements and related financial information.
Management also is responsible for compliance with federal and state laws and
regulations concerning loans to insiders and dividend restrictions designated by
the FDIC as safety and soundness laws and regulations.
Management assessed its compliance with the designated laws and regulations
relating to safety and soundness. Based on this assessment, Management believes
that the Bank complied with the designated laws and regulations relating to
safety and soundness for the year ended December 31, 1999.
Kent A. Steinwert John R. Olson
President & Executive Vice President &
Chief Executive Officer Chief Financial Officer
3
[ARTHUR ANDERSEN LOGO]
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders and the Board of
Directors of Farmers & Merchants Bancorp:
We have audited the accompanying consolidated balance sheets of Farmers &
Merchants Bancorp (a Delaware corporation) and its subsidiaries as of December
31, 1999 and 1998, and the related consolidated statements of income, changes in
shareholders' equity, cash flows and comprehensive income for each of the three
years in the period ended December 31, 1999. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Farmers & Merchants Bancorp and
its subsidiaries as of December 31, 1999 and 1998, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1999 in conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
San Francisco, California
February 4, 2000
4
Consolidated Statements of Income
- ------------------------------------------------------------------------------------------------------------------------
(in thousands except per share data)
Year Ended December 31,
---------------------------------
1999 1998 1997
- -------------------------------------------------------------------------------------------------------------------------
Interest Income
Interest and Fees on Loans $34,593 $29,706 $26,304
Interest on Federal Funds Sold and Securities Purchased
Under Agreements to Resell 793 943 724
Interest on Investment Securities:
Taxable 17,398 17,141 15,298
Tax-Exempt 3,271 3,404 3,649
- -------------------------------------------------------------------------------------------------------------------------
Total Interest Income 56,055 51,194 45,975
- -------------------------------------------------------------------------------------------------------------------------
Interest Expense
Interest on Deposits 16,500 15,780 16,322
Interest on Borrowed Funds 2,362 1,648 100
- -------------------------------------------------------------------------------------------------------------------------
Total Interest Expense 18,862 17,428 16,422
- -------------------------------------------------------------------------------------------------------------------------
Net Interest Income 37,193 33,766 29,553
Provision for Loan Losses 1,700 1,400 5,450
- -------------------------------------------------------------------------------------------------------------------------
Net Interest Income After Provision for Loan Losses 35,493 32,366 24,103
- -------------------------------------------------------------------------------------------------------------------------
Non-Interest Income
Service Charges on Deposit Accounts 3,163 2,842 2,693
Net Gain (Loss) on Sale of Investment Securities (302) 333 202
Credit Card Merchant Fees 783 611 543
Other 2,014 2,033 1,674
- -------------------------------------------------------------------------------------------------------------------------
Total Non-Interest Income 5,658 5,819 5,112
- -------------------------------------------------------------------------------------------------------------------------
Non-Interest Expense
Salaries and Employee Benefits 15,351 14,493 12,816
Occupancy Expense 1,691 1,787 1,842
Equipment Expense 2,268 2,103 1,956
Other 7,711 7,712 7,563
- -------------------------------------------------------------------------------------------------------------------------
Total Non-Interest Expense 27,021 26,095 24,177
- -------------------------------------------------------------------------------------------------------------------------
Income Before Income Taxes 14,130 12,090 5,038
Provision for Income Taxes 4,914 4,030 1,027
- -------------------------------------------------------------------------------------------------------------------------
Net Income $ 9,216 $ 8,060 $ 4,011
=========================================================================================================================
Earnings Per Share $ 13.92 $ 12.13 $ 6.03
=========================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements
5
Consolidated Balance Sheets
- --------------------------------------------------------------------------------------------------------------------------
(in thousands except per share data)
December 31,
-------------------------
Assets 1999 1998
- --------------------------------------------------------------------------------------------------------------------------
Cash and Due from Banks $ 30,384 $ 27,572
Federal Funds Sold and Securities Purchased Under Agreements to Resell 11,600 12,140
Investment Securities:
Available-for-Sale 297,580 312,305
Held-to-Maturity 49,275 60,152
- --------------------------------------------------------------------------------------------------------------------------
Total Investment Securities 346,855 372,457
- --------------------------------------------------------------------------------------------------------------------------
Loans 413,409 329,178
Less: Reserve for Loan Losses 9,787 8,589
- --------------------------------------------------------------------------------------------------------------------------
Loans, Net 403,622 320,589
- --------------------------------------------------------------------------------------------------------------------------
Premises and Equipment, Net 12,707 11,714
Interest Receivable and Other Assets 14,713 14,327
- --------------------------------------------------------------------------------------------------------------------------
Total Assets $819,881 $758,799
==========================================================================================================================
Liabilities
Deposits:
Demand $163,658 $156,586
Interest-Bearing Transaction Accounts 86,503 75,575
Savings 179,294 166,495
Time 255,688 228,731
- --------------------------------------------------------------------------------------------------------------------------
Total Deposits 685,143 627,387
- --------------------------------------------------------------------------------------------------------------------------
Federal Funds Purchased - 2,000
Federal Home Loan Bank Advances 41,064 41,093
Interest Payable and Other Liabilities 13,473 8,914
- --------------------------------------------------------------------------------------------------------------------------
Total Liabilities 739,680 679,394
- --------------------------------------------------------------------------------------------------------------------------
Shareholders' Equity
Preferred Stock: No Par Value. 1,000,000 Authorized, None Issued or Outstanding - -
Common Stock: Stated Value $0.01, 2,000,000 Shares Authorized, 660,989
and 663,295 Issued and Outstanding at December 31, 1999 and 1998, Respectively 7 6
Additional Paid-In Capital 47,993 43,576
Retained Earnings 36,040 34,991
Accumulated Other Comprehensive Income (Loss) (3,839) 832
- --------------------------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 80,201 79,405
- --------------------------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity $819,881 $758,799
==========================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements
6
Consolidated Statements of Changes in Shareholders' Equity
- ------------------------------------------------------------------------------------------------------------------------------------
(in thousands except per share data)
Accumulated
Common Additional Other Total
Shares Common Paid-In Retained Comprehensive Shareholders'
Outstanding Stock Capital Earnings Income (Loss) Equity
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 575,681 $ 6 $35,585 $37,206 $ (80) $72,717
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income 4,011 4,011
Cash Dividends Declared on
Common Stock (2,869) (2,869)
5% Stock Dividend 28,304 3,821 (3,821)
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (62) (62)
Change in Net Unrealized Gain (Loss) on
Securities Available-for-Sale 1,026 1,026
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1997 603,985 $ 6 $39,406 $34,465 $ 946 $74,823
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income 8,060 8,060
Cash Dividends Declared on
Common Stock (3,070) (3,070)
5% Stock Dividend 29,720 4,399 (4,399)
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (65) (65)
Redemption of Stock (1,520) (229) (229)
Change in Net Unrealized Gain (Loss) on
Securities Available-for-Sale (114) (114)
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1998 632,185 $ 6 $43,576 $34,991 $ 832 $79,405
- ------------------------------------------------------------------------------------------------------------------------------------
Net Income 9,216 9,216
Cash Dividends Declared on
Common Stock (3,273) (3,273)
5% Stock Dividend 31,110 1 4,821 (4,822)
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (72) (72)
Redemption of Stock (2,306) (404) (404)
Change in Net Unrealized Gain (Loss) on
Securities Available-for-Sale (4,671) (4,671)
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1999 660,989 $ 7 $47,993 $36,040 $(3,839) $80,201
====================================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements
7
Consolidated Statements of Cash Flows
- ------------------------------------------------------------------------------------------------------------------------------
(in thousands)
Year Ended December 31,
-------------------------------------
1999 1998 1997
- ------------------------------------------------------------------------------------------------------------------------------
Operating Activities
Net Income $ 9,216 $ 8,060 $ 4,011
Adjustments to Reconcile Net Income to Net Cash Provided
by Operating Activities:
Provision for Loan Losses 1,700 1,400 5,450
Depreciation and Amortization 1,770 1,637 1,571
Provision for Deferred Income Taxes (457) (542) 1,146
Net Amortization of Investment Security Premium & Discounts 674 221 449
Net (Gain) Loss on Sale of Investment Securities 302 (333) (202)
Net (Increase) Decrease in Interest Receivable and Other Assets 3,338 (552) 23
Net Increase in Interest Payable and Other Liabilities 4,559 2,454 989
- ------------------------------------------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 21,102 12,345 13,437
- ------------------------------------------------------------------------------------------------------------------------------
Investing Activities
Trading Securities:
Purchased (15,490) (30,345) -
Sold or Matured 15,478 30,454 -
Securities Available-for-Sale:
Purchased (171,788) (171,197) (159,351)
Sold or Matured 177,675 105,926 111,788
Securities Held-to-Maturity:
Purchased (2,114) (4,070) (3,518)
Matured 12,927 42,819 21,336
Net Increase in Loans (85,540) (58,003) (17,056)
Principal Collected on Loans Previously Charged Off 807 432 444
Net Additions to Premises and Equipment (2,763) (1,742) (1,475)
- ------------------------------------------------------------------------------------------------------------------------------
Net Cash Used for Investing Activities (70,808) (85,726) (47,832)
- ------------------------------------------------------------------------------------------------------------------------------
Financing Activities
Net Increase in Demand, Interest-Bearing Transaction,
and Savings Accounts 30,189 29,520 15,587
Net Increase in Time Deposits 27,567 15,834 11,829
Net Increase (Decrease) in Federal Funds Purchased (2,000) 2,000 -
Net Increase (Decrease) in Federal Home Loan Bank Advances (29) 41,093 -
Stock Redemption (404) (229) -
Cash Dividends (3,345) (3,135) (2,932)
- ------------------------------------------------------------------------------------------------------------------------------
Net Cash Provided by Financing Activities 51,978 85,083 24,484
- ------------------------------------------------------------------------------------------------------------------------------
Increase (Decrease) in Cash and Cash Equivalents 2,272 11,702 (9,911)
Cash and Cash Equivalents at Beginning of Year 39,712 28,010 37,921
- ------------------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 41,984 $ 39,712 $ 28,010
==============================================================================================================================
Supplementary Data
Cash Payments made for Income Taxes $ 4,520 $ 5,436 $ 800
Interest Paid $ 18,743 $ 17,685 $ 16,335
==============================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements
8
Consolidated Statements of Comprehensive Income
- -------------------------------------------------------------------------------------------------------------------------
(in thousands)
Year Ended December 31,
---------------------------------
1999 1998 1997
- -------------------------------------------------------------------------------------------------------------------------
Net Income $ 9,216 $8,060 $4,011
Other Comprehensive Income (Loss)
Unrealized Gains (Losses) on Securities:
Unrealized holding gains (losses) arising during the
period, net of income tax effects of $(3,386), $12
and $795 for the years ended December 31, 1999, 1998
and 1997, respectively. (4,841) 18 1,135
Less: Reclassification adjustment for realized gains (losses)
included in net income, net of related income tax effects
of $(119), $92 and $76 for the years ended December 31,
1999, 1998 and 1997, respectively. 170 (132) (109)
- -------------------------------------------------------------------------------------------------------------------------
Total Other Comprehensive Income (Loss) (4,671) (114) 1,026
- -------------------------------------------------------------------------------------------------------------------------
Comprehensive Income $ 4,545 $7,946 $5,037
=========================================================================================================================
The accompanying notes are an integral part of these consolidated financial statements
9
Notes to Consolidated Financial Statements
1. Significant Accounting Policies
Farmers & Merchants Bancorp (the Company) was organized April 30, 1999. Its
primary operations are related to traditional banking activities through its
subsidiary, Farmers & Merchants Bank of Central California (the Bank). The
consolidated financial statements of the Company and its subsidiary, the Bank,
are prepared in conformity with generally accepted accounting principles and
prevailing practices within the banking industry. In preparing the financial
statements, management is required to make estimates and assumptions that affect
reported amounts. These estimates are based on information available as of the
date of the financial statements. Therefore, actual results could differ from
those estimates. The following is a summary of the significant accounting and
reporting policies used in preparing the consolidated financial statements.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the
Company and the Company's wholly owned subsidiary, the Bank, along with the
Bank's wholly owned subsidiaries, Farmers & Merchants Investment Corporation and
Farmers/Merchants Corp. Significant intercompany transactions have been
eliminated in consolidation. Farmers & Merchants Investment Corporation has
been dormant since 1991. Farmers/Merchants Corp. acts as trustee on deeds of
trust originated by the Bank.
Certain amounts in the prior years' financial statements have been reclassified
to conform with the current presentation. These reclassifications have no
effect on previously reported income.
Cash and Cash Equivalents
For purposes of the Consolidated Statements of Cash Flows, the Company has
defined cash and cash equivalents as those amounts included in the balance sheet
captions Cash and Due from Banks and Federal Funds Sold and Securities Purchased
Under Agreements to Resell. Generally, these transactions are for one-day
periods. For these instruments, the carrying amount is a reasonable estimate of
fair value.
Investment Securities
Investment securities are classified at the time of purchase as held-to-maturity
if it is management's intent and the Company has the ability to hold the
securities until maturity. These securities are carried at cost, adjusted for
amortization of premium and accretion of discount using a methodology which
approximates a level yield of interest over the estimated remaining period until
maturity. Losses, reflecting a decline in value judged by the Company to be
other than temporary, are recognized in the period in which they become known.
Securities are classified as available-for-sale if it is management's intent, at
the time of purchase, to hold the securities for an indefinite period of time
and/or to use the securities as part of the Company's asset/liability management
strategy. Securities classified as available-for-sale include securities which
may be sold to effectively manage interest rate risk exposure, prepayment risk,
satisfy liquidity demands and other factors. These securities are reported at
fair value with aggregate, unrealized gains or losses excluded from income and
included as a separate component of shareholders' equity, net of related income
taxes. Fair values are based on quoted market prices or broker/dealer price
quotations on a specific identification basis. Gains or losses on the sale of
these securities are computed using the specific identification method.
Unrealized losses on these securities, reflecting a decline in value judged by
the Company to be other than temporary, are recognized in the period in which
they become known.
Trading securities are acquired for short-term appreciation and are recorded in
a trading portfolio and are carried at fair value, with unrealized gains and
losses recorded in non-interest income.
Loans
Loans are reported at the principal amount outstanding net of unearned discounts
and deferred loan fees. Interest income on loans is accrued daily on the
outstanding balances using the simple interest method. Loan origination fees
are deferred and recognized over the contractual life of the loan as an
adjustment to the yield. Loans are placed
10
on a non-accrual status when the collection of principal or interest is in doubt
or when they become past due for 90 days or more unless they are both well-
secured and in the process of collection. For this purpose a loan is considered
well-secured if it is collateralized by property having a net realizable value
in excess of the amount of the loan or is guaranteed by a financially capable
party. When a loan is placed on non-accrual status, the accrued and unpaid
interest receivable is reversed and charged against current income. Non-accrual
loans are returned to accrual status when the loans are paid current as to
principal and interest and future payments are expected to be made in accordance
with the contractual terms of the loan.
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheets is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate or on the observable or estimated market price of the loan or the fair
value of the collateral if the loan is collateral dependent. Cash payments are
first applied as a reduction of the principal balance until collection of the
remaining principal and interest can be reasonably assured.
Reserve for Loan Losses
As a financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, the reserve for loan
losses is maintained at a level considered adequate by management to provide for
losses that can be reasonably anticipated. The reserve is increased by
provisions charged to operating expense and reduced by net charge-offs.
Management reviews the credit quality of the loan portfolio on a quarterly basis
and considers problem loans, delinquencies, internal credit reviews, current
economic conditions, loan loss experience and other factors in determining the
adequacy of the reserve balance. The reserve is based on estimates, and
ultimate losses may vary from current estimates. The estimates are reviewed
periodically and, as adjustments become necessary, are reported in earnings in
the periods in which they become known. Management has allocated specific
reserves to various loan categories. Nevertheless, the reserve is general in
nature and is available for the loan portfolio as a whole.
Premises and Equipment
Premises, equipment and leasehold improvements are stated at cost, less
accumulated depreciation and amortization. Depreciation is computed principally
by the straight line method over the estimated useful lives of the assets.
Estimated useful lives of buildings range from 30 to 40 years, and for furniture
and equipment from 3 to 8 years. Leasehold improvements are amortized over the
lesser of the terms of the respective leases, or their useful lives, which are
generally 5 to 10 years. Remodeling and capital improvements are capitalized
while maintenance and repairs are charged directly to occupancy expense.
Other Real Estate
Other real estate owned, which is included in other assets, is comprised of
properties acquired through foreclosures in satisfaction of indebtedness. These
properties are carried at the lower of the recorded loan balance or their
estimated net realizable value based on current appraisals. Initial losses on
properties acquired through full or partial satisfaction of debt are treated as
credit losses and charged to the Reserve for Loan Losses at the time of
acquisition. Subsequent declines in value from the recorded amounts, routine
holding costs, and gains or losses upon disposition, if any, are included in
non-interest income or expense as incurred.
Income Taxes
As required, the Company uses the liability method of accounting for income
taxes. This method results in the recognition of deferred tax assets and
liabilities that are reflected at currently enacted income tax rates applicable
to the period in which the deferred tax assets or liabilities are expected to be
realized or settled. As changes in tax laws or rates are enacted, deferred tax
assets and liabilities are adjusted through the provision for income taxes. The
deferred provision for income taxes is the result of the net change in the
deferred tax asset and deferred tax liability balances during the year. This
amount combined with the current taxes payable or refundable results in the
income tax expense for the current year.
11
Earnings Per Share
Earnings per share amounts are computed by dividing net income by the weighted
average number of common shares outstanding at the end of the year. Prior
years have been restated for the 5% stock dividend paid in each of the years
presented.
Comprehensive Income
On January 1, 1998, the Company adopted the Statement of Financial Accounting
Standards, Reporting Comprehensive Income. This statement establishes standards
for the reporting and display of comprehensive income and its components in the
financial statements. Other comprehensive income refers to revenues, expenses,
gains and losses that generally accepted accounting principles recognize as
changes in value to an enterprise but are excluded from net income. For the
Company, comprehensive income includes net income (loss) and changes in fair
value of its available-for-sale investment securities.
2. Securities Purchased Under Agreements to Resell
The Bank enters into purchases and sales of securities under agreements to
resell substantially identical securities. These types of security transactions
are generally for one day periods and are primarily whole loan securities rated
AA or better. During 1999, the underlying securities purchased under resale
agreements were delivered into the Bank's account at a third-party custodian
that recognizes the Company's rights and interest in these securities.
3. Investment Securities
The amortized cost, fair values and unrealized gains and losses of the
securities available-for-sale are as follows: (in thousands)
Gross Unrealized
Amortized ------------------------ Fair/Book
December 31, 1999 Cost Gains Losses Value
- -------------------------------------------------------------------------------------------------------------------
U.S. Treasury Securities $ 12,158 $ 3 $ 286 $ 11,875
Securities of U.S. Government Agencies and Corporations 7,156 - 143 7,013
Obligations of States and Political Subdivisions 24,093 3 1,054 23,042
Mortgage-Backed Securities 256,051 108 5,156 251,003
Other 4,647 - - 4,647
- -------------------------------------------------------------------------------------------------------------------
Total $304,105 $ 114 $6,639 $297,580
===================================================================================================================
December 31, 1998
- -------------------------------------------------------------------------------------------------------------------
U.S. Treasury Securities $ 9,030 $ 69 $ - $ 9,099
Securities of U.S. Government Agencies and Corporations 11,974 164 - 12,138
Obligations of States and Political Subdivisions 23,823 298 74 24,047
Mortgage-Backed Securities 256,685 1,442 483 257,644
Other 9,377 - - 9,377
- -------------------------------------------------------------------------------------------------------------------
Total $310,889 $1,973 $ 557 $312,305
===================================================================================================================
12
The book values, estimated fair values, and unrealized gains and losses of
investments classified as held-to-maturity are as follows: (in thousands)
Gross Unrealized
Book ------------------------ Fair
December 31, 1999 Value Gains Losses Value
- -------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies and Corporations $ 1,995 $ - $ 10 $ 1,985
Obligations of States and Political Subdivisions 46,423 344 257 46,510
Other 857 59 - 916
- -------------------------------------------------------------------------------------------------------------------
Total $49,275 $ 403 $ 267 $ 49,411
===================================================================================================================
December 31, 1998
- -------------------------------------------------------------------------------------------------------------------
U.S. Treasury Securities $ 2,006 $ 11 $ - $ 2,017
Securities of U.S. Government Agencies and Corporations 1,990 41 - 2,031
Obligations of States and Political Subdivisions 55,088 1,845 - 56,933
Other 1,068 100 - 1,168
- -------------------------------------------------------------------------------------------------------------------
Total $60,152 $1,997 $ - $ 62,149
===================================================================================================================
Fair values are based on quoted market prices or dealer quotes. If a quoted
market price is not available, fair value is estimated using quoted market
prices for similar securities.
The remaining principal maturities of debt securities as of December 31, 1999
and 1998 are shown below. Expected maturities may differ from contractual
maturities as borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties.
After 1 After 5 Total
Securities Available-for-Sale Within but but Over Fair
December 31, 1999 (in thousands) 1 Year Within 5 Within 10 10 years Value
- -------------------------------------------------------------------------------------------------------------------
U.S. Treasury Securities $ 2,006 $ 9 ,869 $ - $ - $ 11,875
Securities of U.S. Government
Agencies and Corporations - 7,013 - - 7,013
Obligations of States and Political
Subdivisions 1,000 5,157 13,381 3,504 23,042
Mortgage-Backed Securities 8,759 194,843 46,640 761 251,003
Other 4,647 - - - 4,647
- -------------------------------------------------------------------------------------------------------------------
Total $16,412 $216,882 $60,021 $ 4,265 $297,580
===================================================================================================================
1998 Totals $ 57,078 $203,462 $38,972 $12,793 $312,305
===================================================================================================================
After 1 After 5 Total
Securities Held-to-Maturity Within but but Over Book
December 31, 1999 (in thousands) 1 Year Within 5 Within 10 10 years Value
- -------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government
Agencies and Corporations $ - $ 1,995 $ - $ - 1,995
Obligations of States and Political
Subdivisions 7,494 21,884 16,691 354 46,423
Other - - - 857 857
- -------------------------------------------------------------------------------------------------------------------
Total $ 7,494 $ 23,879 $16,691 $ 1,211 $ 49,275
===================================================================================================================
1998 Totals $ 8,260 $ 29,883 $18,760 $ 3,249 $ 60,152
===================================================================================================================
13
Proceeds from sales of securities available-for-sale were as follows: (in
thousands)
Gross Gross Gross
Proceeds Gains Losses
- -------------------------------------------------------------------------------------------------------------------
1999 $54,231 $285 $118
1998 $16,254 $137 $ 1
1997 $89,018 $150 $466
As of December 31, 1999, securities carried at $131,848,000 were pledged to
secure public and other deposits as required by law.
4. Loans and Reserve for Loan Losses
Loans as of December 31, consisted of the following: (in thousands)
1999 1998
- ------------------------------------------------------------------------------------------------------------------
Real Estate $222,354 $180,468
Real Estate Construction 39,186 26,529
Commercial 129,969 105,403
Consumer 22,248 17,088
- ------------------------------------------------------------------------------------------------------------------
413,757 329,488
Less: Unearned Income on Loans (348) (310)
- ------------------------------------------------------------------------------------------------------------------
Total Loans $413,409 $329,178
==================================================================================================================
Non-Accrual Loans $ 2,499 $ 4,601
==================================================================================================================
The estimated fair value of the Company's net loan portfolio was $407,070,000
and $333,951,000 for the years ended December 31, 1999 and 1998, respectively.
The fair value of the loan portfolio is estimated by discounting the future
estimated cash flows using the Company's current rates at which similar loans
would be made to borrowers with similar credit ratings for the same remaining
maturities.
Changes in the reserve for loan losses consisted of the following:
(in thousands)
1999 1998 1997
- -------------------------------------------------------------------------------------------------------------
Balance, January 1 $ 8,589 $7,188 $10,031
Provision Charged to Operating Expense 1,700 1,400 5,450
Recoveries of Loans Previously Charged Off 807 432 444
Loans Charged Off (1,309) (431) (8,737)
- -------------------------------------------------------------------------------------------------------------
Balance, December 31 $ 9,787 $8,589 $ 7,188
=============================================================================================================
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheets is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate or on the observable or estimated market price of the loan or the fair
value of the collateral if the loan is collateral dependent. All impaired loans
have been assigned a related reserve for credit losses. As of December 31, 1999
and 1998 the total recorded investment in impaired loans was $2,499,000 and
$1,571,000, respectively. The related allowance for credit losses was $364,000
and $328,000 for the years ended 1999 and 1998, respectively. This reserve is
included in the reserve for loan losses reported above. For income reporting
purposes, impaired loans are placed on a non-accrual status and are more fully
discussed in Note 1. Cash payments are first applied as a reduction of the
loan's principal balance until collection of the remaining principal and
interest can be reasonably assured. Thereafter, interest income is recognized
as it is collected in cash. The average balance of impaired loans was $3.4
million and $1.5 million for the years ended 1999 and 1998, respectively. There
was no interest income
14
forgone on loans placed on non-accrual status was $48,000, $681,000 and
$813,000 as of December 31, 1999, 1998 and 1997, respectively.
5. Premises and Equipment
Premises and equipment as of December 31, consisted of the following:
(in thousands) 1999 1998
- -------------------------------------------------------------------------------------------------
Land and Buildings $15,226 $13,067
Furniture, Fixtures and Equipment 14,085 14,204
Leasehold Improvements 835 839
- -------------------------------------------------------------------------------------------------
30,146 28,110
Less: Accumulated Depreciation and Amortization 17,439 16,396
- -------------------------------------------------------------------------------------------------
Total $12,707 $11,714
=================================================================================================
Depreciation and amortization on premises and equipment included in occupancy
and equipment expense amounted to $1,770,000, $1,637,000 and $1,571,000 for the
years ended December 31, 1999, 1998 and 1997, respectively. Total rental
expense for premises were $240,000, $228,000 and $221,000 for the years ended
December 31, 1999, 1998 and 1997, respectively. Rental income was $81,000,
$68,000 and $87,000 for the years ended December 31, 1999, 1998 and 1997,
respectively.
6. Other Real Estate
Other real estate, included in Interest Receivable and Other Assets, totaled
$204,000 and $636,000 at December 31, 1999 and 1998, respectively. Other real
estate includes property no longer utilized for business operations and property
acquired through foreclosure proceedings. These properties are carried at the
lower of cost or estimated net realizable value determined at the date acquired.
Losses arising from the acquisition of these properties are charged against the
reserve for loan losses. Subsequent declines in value, routine holding costs and
net gains or losses on disposition are included in other operating expense as
incurred.
7. Deposits
Deposits of $100,000 or more were as follows:
(in thousands) December 31,
-----------------------------------
1999 1998 1997
- -----------------------------------------------------------------------------------------------------
Balance $74,259 $62,371 $66,937
=====================================================================================================
At December 31, 1999, the scheduled maturities of time deposits were as follows:
(in thousands) Scheduled
Maturities
2000 $218,413
2001 29,496
2002 7,418
2003 200
2004 and thereafter 161
- ----------------------------------------------------------------------------
Total $255,688
============================================================================
The fair values of the Company's deposit liabilities were $620,892,000 and
$628,572,000 for the years ended December 31, 1999 and 1998, respectively. The
fair value of demand deposits, interest bearing transaction accounts and savings
accounts is the amount payable on demand as of December 31. The fair value of
fixed-maturity certificates of deposit is estimated by discounting expected
future cash flows utilizing interest rates currently being offered for deposits
of similar remaining maturities.
15
8. Income Taxes
Current and deferred income tax expense (benefit) provided for the years ended
December 31, consisted of the following:
(in thousands) 1999 1998 1997
- ---------------------------------------------------------------------------------------------------------
Current
Federal $3,764 $3,220 $ (237)
State 1,607 1,352 118
- ---------------------------------------------------------------------------------------------------------
Total Current 5,371 4,572 (119)
- ---------------------------------------------------------------------------------------------------------
Deferred
Federal (383) (502) 717
State (74) (40) 429
- ---------------------------------------------------------------------------------------------------------
Total Deferred (457) (542) 1,146
- ---------------------------------------------------------------------------------------------------------
Total Provision for Taxes $4,914 $4,030 $1,027
=========================================================================================================
The total provision for income taxes differs from the federal statutory rate as
follows:
(in thousands)
1999 1998 1997
-------------------------- -------------------------- --------------------------
Amount Rate Amount Rate Amount Rate
- -----------------------------------------------------------------------------------------------------------------------------------
Tax Provision at Federal Statutory Rate $ 4,804 34.0 % $ 4,111 34.0 % $ 1,713 34.0 %
Interest on Obligations of States
and Political Subdivisions
Exempt from Federal Taxation (1,008) (7.1)% (1,001) (8.3)% (1,099) (21.8)%
State and Local Income Taxes,
Net of Federal Income Tax Benefit 1,012 7.2 % 866 7.2 % 361 7.2 %
Other, Net 106 0.7 % 54 0.4 % 52 1.0 %
- -----------------------------------------------------------------------------------------------------------------------------------
Total Provision for Taxes $ 4,914 34.8 % $ 4,030 33.3 % $ 1,027 20.4 %
===================================================================================================================================
The components of the net deferred tax assets as of December 31, are as follows:
(in thousands) 1999 1998
- --------------------------------------------------------------------------------------------------------------------
Deferred Tax Assets
Reserve for Loan Losses $ 3,720 $3,243
Unrealized (Loss) Gain on Securities Available-for-Sale 2,685 (584)
Accrued Liabilities 1,021 868
Deferred Compensation 666 532
Other Real Estate 468 360
State Franchise Tax 521 446
Interest on Non-Accrual Loans 108 330
- --------------------------------------------------------------------------------------------------------------------
Total Deferred Tax Assets 9,189 5,195
- --------------------------------------------------------------------------------------------------------------------
Deferred Tax Liabilities
Depreciation (532) (623)
Securities Accretion (477) (248)
Other (226) (96)
- --------------------------------------------------------------------------------------------------------------------
Total Deferred Tax Liabilities (1,235) (967)
- --------------------------------------------------------------------------------------------------------------------
Net Deferred Tax Assets $ 7,954 $4,228
====================================================================================================================
The net deferred tax assets are reported in Interest Receivable and Other Assets
on the Company's Consolidated Balance Sheets. Prior year totals have been
restated to conform with the tax return as filed.
16
9. Short Term Borrowings
As of December 31, 1999 and 1998, the Company had unused lines of credit
available for short term liquidity purposes of $136 million. Federal Funds
purchased and advances from the Federal Reserve Bank are generally issued on an
overnight basis.
10. Federal Home Loan Bank Advances
The Company's advances from the Federal Home Loan Bank of San Francisco consist
of the following as of December 31,
(in thousands) 1999 1998
- -------------------------------------------------------------------------------------------------------------------
5.35% note payable due February 2, 2008 with interest due quarterly, callable
February 2, 2003 and quarterly thereafter. $25,000 $25,000
5.38% note payable due August 12, 2008 with interest due quarterly, callable
August 12, 2003 and quarterly thereafter. 15,000 15,000
5.60% amortizing note, interest and principal payable monthly with final
maturity of September 25, 2018. 1,064 1,093
- -------------------------------------------------------------------------------------------------------------------
Total $41,064 $41,093
===================================================================================================================
In accordance with the Collateral Pledge and Security Agreement, advances are
secured by all Federal Home Loan Bank stock held by the company and by agency
and mortgage-backed securities with carrying values of $50,035,000 and
approximate market values of $48,533,000.
The fair value of advances from the Federal Home Loan Bank was $38,936,000 and
$41,088,000 at December 31, 1999 and 1998, respectively.
11. Shareholders' Equity
Beginning in 1975 and continuing through 1999, the Company has issued an annual
5% stock dividend. Earnings per share amounts have been restated for each year
presented to reflect the stock dividend.
Dividends from the Bank constitute the principal source of cash to the Company.
The Company is a legal entity separate and distinct from the Bank. Under
regulations controlling California state chartered banks, the Bank is, to some
extent, limited in the amount of dividends that can be paid to the Company
without prior approval of the California State Department of Financial
Institutions (DFI). These regulations limit total dividends declared by a state
chartered bank to the lesser of (1) retained earnings or (2) the bank's net
profits less distributions for the preceding three calendar years. As of
December 31, 1999, the Bank could declare dividends of $11,875,000 without
approval of the DFI. These regulations apply to all California state chartered
banks.
The Accumulated Other Comprehensive Income is the result of the accounting
standard, Reporting Comprehensive Income. This accounting principle requires
securities classified as available-for-sale be reported at their fair values.
Unrealized gains and losses are reported on a net-of-tax basis as a component of
Shareholders' Equity.
The Company and the Bank are subject to various regulatory capital requirements
administered by the Federal Reserve Bank of San Francisco and the Federal
Deposit Insurance Corporation. These guidelines are designed to make capital
requirements more sensitive to differences in risk related assets among banking
organizations, to take into account off-balance sheet exposures and aid in
making the definition of banking capital uniform. Bank assets and off-balance
sheet items are categorized by risk. The results of these regulations are that
assets with a higher degree of risk require a larger amount of capital; assets,
such as cash, with a low degree of risk have little or no capital requirements.
Failure to meet these minimum capital requirements can initiate certain
disciplinary actions by regulators. As of December 31, 1999 and 1998, the
Company and the Bank meet all capital adequacy requirements to which they are
subject and was categorized as a well capitalized bank by the FDIC. The
following table illustrates the relationship between the regulatory capital
requirements and the Company and Bank's capital position. (Bank only is
presented for 1998.)
17
To Be Well
Capitalized Under
Regulatory Capital Prompt Corrective
(in thousands) Actual Requirements Action Provisions
December 31, 1999 Amount Ratio Amount Ratio Amount Ratio
- -------------------------------------------------------------------------------------------------------------------------
Total Bank Capital to Risk Weighted Assets $89,573 16.70% $42,915 8.0% $53,644 10.0%
Total Consolidated Capital to Risk Weighted Assets $90,784 16.92% $42,922 8.0% $53,653 10.0%
Tier I Bank Capital to Risk Weighted Assets $82,829 15.44% $21,458 4.0% $32,187 6.0%
Tier I Consolidated Capital to Risk Weighted Assets $84,040 15.66% $21,461 4.0% $32,192 6.0%
Tier I Bank Capital to Average Assets $82,829 10.37% $31,938 4.0% $39,923 5.0%
December 31, 1998
- -------------------------------------------------------------------------------------------------------------------------
Total Capital to Risk Weighted Assets $84,106 20.80% $32,344 8.0% $40,431 10.0%
Tier I Capital to Risk Weighted Assets $79,009 19.54% $16,172 4.0% $24,258 6.0%
Tier I Capital to Average Assets $79,009 11.45% $27,598 4.0% $34,497 5.0%
12. Employee Benefit Plans
The Company, through the Bank, sponsors a defined benefit pension plan covering
all employees of Farmers & Merchants Bank of Central California who have
completed one year of service and attained age 21.
The Plan provides benefits, up to a maximum stated in the plan, based on each
covered employee's years of service and highest five-year average compensation
earned while a participant in the plan.
Plan benefits are fully vested after five years of plan service.
The Company's funding policy is to contribute annually an amount that is not
less than the ERISA minimum funding requirement and not in excess of the maximum
tax-deductible contribution as developed in accordance with the aggregate cost
method.
The following schedule states the change in benefit obligations for the years
ended December 31:
(in thousands) 1999 1998
- --------------------------------------------------------------------------------------------------------------------
Benefit Obligation at Beginning of Year $5,009 $4,320
Service Cost 536 441
Interest Cost 360 331
Benefits Paid (779) (762)
Actuarial Loss 137 679
- --------------------------------------------------------------------------------------------------------------------
Total Benefit Obligation at End of Year $5,263 $5,009
====================================================================================================================
The Change in Plan Assets are as follows: (in thousands) 1999 1998
- --------------------------------------------------------------------------------------------------------------------
Fair Value of Plan Assets at Beginning of Year $4,959 $4,520
Employer Contribution 666 612
Benefits Paid (779) (762)
Actual Return on Plan Assets 659 589
- --------------------------------------------------------------------------------------------------------------------
Total Fair Value of Plan Assets at End of Year $5,505 $4,959
====================================================================================================================
18
The following table sets forth the Plan's funded status along with amounts
recognized and not recognized in the Bank's Consolidated Balance Sheets for the
years ended December 31:
(in thousands) 1999 1998
- --------------------------------------------------------------------------------------------------------------------
Benefit Obligation $5,263 $5,009
Fair Value of Plan Assets 5,505 4,959
- --------------------------------------------------------------------------------------------------------------------
Funded Status 242 (50)
Unrecognized Net (Asset) at Transition (114) (142)
Unrecognized Prior Service Cost (69) (77)
Unrecognized Net Loss 492 684
- --------------------------------------------------------------------------------------------------------------------
Net Amounts Recognized $ 551 $ 415
====================================================================================================================
Amounts Recognized:
- --------------------------------------------------------------------------------------------------------------------
Prepaid Benefit Cost $ 551 $ 415
Accrued Benefit Liability - -
Intangible Asset - -
- --------------------------------------------------------------------------------------------------------------------
Net Amounts Recognized $ 551 $ 415
====================================================================================================================
The components of the net periodic benefit costs are as follows:
(in thousands) 1999 1998 1997
- -------------------------------------------------------------------------------------------------------------------------
Service Cost $ 536 $ 441 $ 402
Interest Cost 360 331 318
Expected Return on Plan Assets (426) (355) (265)
Amortization of
Unrecognized Net Asset at Transition (28) (28) (28)
Unrecognized Prior Service Cost (7) (7) (7)
Unrecognized Net Loss 96 49 31
- -------------------------------------------------------------------------------------------------------------------------
Total Net Periodic Benefit Cost $ 531 $ 431 $ 451
=========================================================================================================================
Assumptions Used in the Accounting were:
Discount Rate (Settlement Rate) 7.50% 6.50% 7.00%
Rate of Increase in Salary Levels 4.00% 5.00% 5.00%
Expected Return on Assets 9.00% 9.00% 8.00%
=========================================================================================================================
Substantially all full-time employees of the Bank with one or more years of
service also participate in a defined contribution profit sharing plan.
Contributions to this plan are made at the discretion of the Board of Directors
and the Board can terminate the plan at any time. The Bank contributed
$485,000, $465,000 and $420,000 for the years ended December 31, 1999, 1998 and
1997, respectively. The employees are permitted, within limitations imposed by
tax law, to make pretax contributions to the 401(k) feature of the Plan. The
Bank does not match employee contributions within the 401(k) feature of the
Plan.
The Bank sponsors a Deferred Bonus Plan for certain employees. Deferred bonuses
are granted and benefits accumulate based on the cumulative profits during the
employee's participation period. The Bank contributed $111,000 and $54,000 for
the years ended December 31, 1999 and 1998, respectively.
13. Commitments and Contingencies
In the normal course of business, the Company is a party to financial
instruments with off-balance sheet risk to meet the financing needs of its
customers and to reduce its own exposure to fluctuations in interest rates.
These instruments include commitments to extend credit, letters of credit and
financial guarantees that are not reflected in the Consolidated Balance Sheets.
19
The Company's exposure to credit loss in the event of nonperformance by the
other party with regards to standby letters of credit, undisbursed loan
commitments and financial guarantees is represented by the contractual notional
amount of those instruments. Commitments to extend credit are agreements to
lend to a customer as long as there is no violation of any condition established
in the contract. The Company uses the same credit policies in making
commitments and conditional obligations as it does for recorded balance sheet
items. The Company may or may not require collateral or other security to
support financial instruments with credit risk. Evaluations of each customer's
creditworthiness are performed on a case-by-case basis.
Standby letters of credit are conditional commitments issued by the Company to
guarantee performance of or payment for a customer to a third party. The
Company had standby letters of credit outstanding of $6,635,000 at December 31,
1999, and $6,019,000 at December 31, 1998. Commitments to extend credit are
agreements to lend to a customer as long as there is no violation of any
condition contained in the contract. Commitments generally have fixed expiration
dates or other termination clauses and may require payment of a fee.
Undisbursed loan commitments totaled $153,329,000 and $123,598,000 as of
December 31, 1999 and 1998, respectively. Since many of these commitments are
expected to expire without fully being drawn upon, the total commitment amounts
do not necessarily represent future cash requirements. The Company does not
anticipate any loss as a result of these transactions.
The Company is obligated under a number of noncancellable operating leases for
premises and equipment used for banking purposes. Minimum future rental
commitments under noncancellable operating leases as of December 31, 1999 were
$117,000, and $43,000 for the years ended December 31, 2000 through 2001,
respectively; and none thereafter.
In the ordinary course of business, the Company becomes involved in litigation
arising out of its normal business activities. Management, after consultation
with legal counsel, is of the opinion that the ultimate liability, if any,
resulting from the disposition of such claims would not be material in relation
to the financial position of the Company.
The Company may be required to maintain average reserves on deposit with the
Federal Reserve Bank primarily based on deposits outstanding. There were no
reserve requirements during 1999 or at December 31, 1999 and 1998.
14. Transactions with Related Parties
The Company, in the ordinary course of business, has had, and expects to have in
the future, deposit and loan transactions with Directors, executive officers and
their affiliated companies. These transactions were on substantially the same
terms, including interest rates, as those prevailing at the time for comparable
transactions with unaffiliated parties and do not involve more than normal
credit risk or other unfavorable features.
Loan transactions with Directors, executive officers and their affiliated
companies during the year ended December 31, 1999, were as follows:
(in thousands)
- ------------------------------------------------------------------------------------------------------------------
Loan Balances December 31, 1998 $ 2,692
Disbursements During 1999 476
Loan Reductions During 1999 (2,063)
- ------------------------------------------------------------------------------------------------------------------
Loan Balances December 31, 1999 $ 1,105
==================================================================================================================
15. Future Impact of Accounting Standards Not Yet Adopted
The Financial Accounting Standards Board (FASB) has issued an accounting
statement that has yet to be adopted by the Company. The following is a brief
description of this statement.
In June 1998, the FASB issued the accounting standard "Accounting for Derivative
Instruments and Hedging Activities". This statement establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. This
statement is effective
20
for fiscal years beginning after June 15, 2000. The Company does not believe
that the adoption of this new accounting standard will have a material impact on
its operations and financial position.
16. Parent Company Financial Information
Farmers & Merchants Bancorp was organized April 30, 1999. As a result,
comparative financial information is not available. The financial information
below is for the eight-month period ended December 31, 1999.
Farmers & Merchants Bancorp
Balance Sheet
(in thousands) 1999
- ----------------------------------------------------------------------------------------------------------------
Cash $ 1,126
Investment in Farmers & Merchants Bank of Central California 78,991
Other Assets 84
- ----------------------------------------------------------------------------------------------------------------
Total Assets $80,201
================================================================================================================
Liabilities $ -
Shareholders' Equity 80,201
- ----------------------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders Equity $80,201
================================================================================================================
Farmers & Merchants Bancorp
Income Statement
for the eight month period ending December 31,
1999
- ----------------------------------------------------------------------------------------------------------------
Equity Earnings in Farmers & Merchants Bank of Central California $6,298
Other Expenses, Net (116)
- ----------------------------------------------------------------------------------------------------------------
Net Income $6,182
================================================================================================================
21
Farmers & Merchants Bancorp
Statement of Cash Flows
for the eight month period ending December 31,
1999
- -----------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Net Income $ 6,182
Adjustments to Reconcile Net Income to Net Cash Used in Operating Activities:
Earnings from Farmers & Merchants Bank of Central California (6,298)
Net (Increase) in Interest Receivable and Other Assets (84)
- -----------------------------------------------------------------------------------------------------------------
Net Cash Used in Operating Activities (200)
- -----------------------------------------------------------------------------------------------------------------
Investing Activities:
Dividends Received from Farmers & Merchants Bank of Central California 5,075
- -----------------------------------------------------------------------------------------------------------------
Net Cash Provided by Investing Activities 5,075
- -----------------------------------------------------------------------------------------------------------------
Financing Activities:
Stock Redemption (404)
Cash Dividends (3,345)
- -----------------------------------------------------------------------------------------------------------------
Net Cash Used by Financing Activities (3,749)
- -----------------------------------------------------------------------------------------------------------------
Increase in Cash and Cash Equivalents 1,126
Cash and Cash Equivalents at Beginning of Year -
- -----------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 1,126
=================================================================================================================
22
Five Year Financial Summary of Operations
(in thousands, except per share data)
1999 1998 1997 1996 1995
- --------------------------------------------------------------------------------------------------------------
Total Interest Income $ 56,055 $ 51,194 $ 45,975 $ 45,060 $ 42,381
Total Interest Expense 18,862 17,428 16,422 15,557 15,238
- --------------------------------------------------------------------------------------------------------------
Net Interest Income 37,193 33,766 29,553 29,503 27,143
Provision for Loan Losses 1,700 1,400 5,450 4,000 1,000
- --------------------------------------------------------------------------------------------------------------
Net Interest income After
Provision for Loan Losses 35,493 32,366 24,103 25,503 26,143
Total Non-Interest Income 5,658 5,819 5,112 5,157 4,687
Total Non-Interest Expense 27,021 26,095 24,177 22,013 20,764
- --------------------------------------------------------------------------------------------------------------
Income Before Income Taxes 14,130 12,090 5,038 8,647 10,066
Provision for Income Taxes 4,914 4,030 1,027 1,566 3,033
- --------------------------------------------------------------------------------------------------------------
Net Income $ 9,216 $ 8,060 $ 4,011 $ 7,081 $ 7,033
==============================================================================================================
Balance Sheet Data
Investment Securities $346,855 $374,170 $346,125 $314,881 $287,413
Loans 413,409 329,178 271,606 263,287 258,489
Reserve for Loan Losses 9,787 8,589 7,188 10,031 7,089
Deposits 685,143 627,387 582,033 554,617 525,437
Federal Home Loan Bank Advances 41,064 41,093 - - -
Shareholders' Equity 80,201 79,405 74,823 72,717 68,342
Selected Ratios
Return on Average Assets 1.19% 1.17% .63% 1.17% 1.22%
Return on Average Equity 11.10% 10.16% 5.43% 9.89% 10.69%
Dividend Payout Ratio 36.30% 38.91% 73.10% 39.08% 36.30%
Average Loan to Average Deposits 52.93% 48.93% 47.07% 50.28% 48.20%
Average Equity to Average Assets Ratio 10.86% 11.33% 11.65% 11.91% 11.63%
Per Share Data (1)
Net Income $ 13.92 $ 12.13 $ 6.03 $ 10.65 $ 10.58
Cash Dividends Declared $ 4.95 $ 4.62 $ 4.32 $ 4.07 $ 3.76
(1) Based on the weighted average number of shares outstanding of 662,268,
664,609 and 664,815 for the years ended December 31, 1999, 1998 and 1997
respectively. Prior years have been adjusted for 5% stock dividends issued in
each of the above years.
23
Quarterly Financial Data
(in thousands, except for per share data)
First Second Third Fourth
1999 Quarter Quarter Quarter Quarter Total
- -----------------------------------------------------------------------------------------------------
Total Interest Income $12,867 $13,804 $14,481 $14,903 $56,055
Total Interest Expense 4,548 4,564 4,752 4,998 18,862
- -----------------------------------------------------------------------------------------------------
Net Interest Income 8,319 9,240 9,729 9,905 37,193
Provision for Loan Losses 300 600 500 300 1,700
- -----------------------------------------------------------------------------------------------------
Net Interest Income After
Provision for Loan Losses 8,019 8,640 9,229 9,605 35,493
Total Non-Interest Income 1,547 1,479 1,574 1,058 5,658
Total Non-Interest Expense 6,040 6,584 7,084 7,313 27,021
- -----------------------------------------------------------------------------------------------------
Income Before Income Taxes 3,526 3,535 3,719 3,350 14,130
Provision for Income Taxes 1,213 1,222 1,316 1,163 4,914
- -----------------------------------------------------------------------------------------------------
Net Income $ 2,313 $ 2,313 $ 2,403 $ 2,187 $ 9,216
=====================================================================================================
Earnings Per Share $3.49 $3.49 $3.63 $3.31 $13.92
=====================================================================================================
1998
- -----------------------------------------------------------------------------------------------------
Total Interest Income $12,325 $12,946 $13,010 $12,913 $51,194
Total Interest Expense 4,141 4,229 4,405 4,653 17,428
- -----------------------------------------------------------------------------------------------------
Net Interest Income 8,184 8,717 8,605 8,260 33,766
Provision for Loan Losses 300 300 300 500 1,400
- -----------------------------------------------------------------------------------------------------
Net Interest Income After
Provision for Loan Losses 7,884 8,417 8,305 7,760 32,366
Total Non-Interest Income 1,409 1,446 1,367 1,597 5,819
Total Non-Interest Expense 6,103 6,491 6,448 7,053 26,095
- -----------------------------------------------------------------------------------------------------
Income Before Income Taxes 3,190 3,372 3,224 2,304 12,090
Provision for Income Taxes 1,114 1,155 1,096 665 4,030
- -----------------------------------------------------------------------------------------------------
Net Income $ 2,076 $ 2,217 $ 2,128 $ 1,639 $ 8,060
=====================================================================================================
Earnings Per Share $3.12 $3.33 $3.20 $2.47 $12.13
=====================================================================================================
Farmers & Merchants Bancorp stock is not traded on any exchange. The shares are
primarily held by local residents and are not actively traded. Dividends
declared semiannually during the past three years were for the following
amounts: June 1999, 1998 and 1997, $1.70, $1.57 and $1.45 per share,
respectively, and for December 1999, 1998, and 1997, $3.25, $3.05 and $2.87 per
share, respectively. Based on information from shareholders and from Company
stock transfer records, the prices paid in 1999, 1998 and 1997 ranged from
$135.00 to $210.00 per share
24
Management's Discussion and Analysis
Forward-Looking Statements
This annual report contains various forward-looking statements, usually
containing the words "estimate," "project," "expect," "objective," "goal," or
similar expressions and includes assumptions concerning the Company's
operations, future results, and prospects. These forward-looking statements are
based upon current expectations and are subject to risk and uncertainties. In
connection with the "safe-harbor" provisions of the private Securities
Litigation Reform Act of 1995, the Company provides the following cautionary
statement identifying important factors which could cause the actual results of
events to differ materially from those set forth in or implied by the forward-
looking statements and related assumptions.
Such factors include the following: (i) the effect of changing regional and
national economic conditions; (ii) significant changes in interest rates and
prepayment speeds; (iii) credit risks of commercial, real estate, consumer, and
other lending activities; (iv) changes in federal and state banking regulations;
(v) other external developments which could materially impact the Company's
operational and financial performance. Readers are cautioned not to place undue
reliance on these forward-looking statements which speak only as of the date
hereof. The Company undertakes no obligation to update any forward-looking
statements to reflect events or circumstances arising after the date on which
they are made.
Introduction
The following discussion and analysis is intended to provide a better
understanding of Farmers & Merchants Bancorp and subsidiaries' performance
during 1999 and the material changes in financial condition, operating income
and expense of the Company and its subsidiaries as shown in the accompanying
financial statements.
Farmers & Merchants Bancorp is a bank holding company formed April 30, 1999.
Its subsidiary, Farmers & Merchants Bank of Central California is a state
chartered bank with 18 offices located in Sacramento, San Joaquin and Stanislaus
Counties. Virtually all of the Company's business activities are conducted
within its market area.
This section should be read in conjunction with the consolidated financial
statements and the notes thereto, along with other financial information
included in this report. Per share amounts for 1998 and 1997 have been restated
to reflect the 5% stock dividend declared during 1999.
Overview
At the completion of our 83rd year, management is pleased to present the highest
reported income in the Company's history. As of December 31, 1999, Farmers &
Merchants Bancorp reported net income of $9,216,000, earnings per share of
$13.92, return on average assets of 1.19% and return on average equity of
11.10%. For the year 1998, net income totaled $8,060,000, earnings per share
was $12.13 for the year, return on average assets was 1.17%, and the return on
average shareholders' equity totaled 10.16%. As for 1997, net income was
$4,011,000, earnings per share was $6.03, while return on average assets was
0.63% and the return on average shareholders' equity was 5.43%.
As of December 31, 1999, consolidated assets were $819.9 million, gross loans
were $413.4 million and deposits were $685.1 million. Total consolidated assets
increased $61.1 million, gross loans increased $84.2 million and deposits grew
$57.8 million.
The Company's improved financial performance in 1999 was due to a combination of
increased revenue generated from its core business, improvement in the credit
quality of the loan portfolio and effective capital management strategies.
The following is a summary of the financial accomplishments achieved during
1999:
. Net interest income increased 10.2% to $37,193,000 from $33,766,000 reported
during 1998.
. The provision for loan losses increased to $1,700,000 during 1999 compared to
$1,400,000 in 1998.
25
. Non-interest income (net of securities transactions) increased 8.6% during
1999, when compared to 1998.
. Non-interest expense increased $926,000 or 3.5% during 1999 compared to an
increase of 7.9% in 1998.
. Total assets increased 8.0% to $819,881,000.
. Total loans increased 25.6% to $413,409,000.
. Non-accrual loans decreased 45.7% and totaled $2.5 million at December 31.
. Total investment securities decreased to $346,855,000 from $372,457,000 in
1998.
. Total Shareholders' Equity increased to $80,201,000.
Net Interest Income
Net interest income is the amount by which the interest and fees on loans and
interest earned on earning assets exceeds the interest paid on interest bearing
sources of funds. For the purpose of analysis, the interest earned on tax-
exempt investments and municipal loans is adjusted to an amount comparable to
interest subject to normal income taxes. This adjustment is referred to as
"taxable equivalent" and is noted wherever applicable. Interest income and
expense are affected by changes in the volume and mix of average interest
earning assets and average interest bearing liabilities, as well as fluctuations
in interest rates. Therefore, increases or decreases in net interest income are
analyzed as changes in volume, changes in rate and changes in the mix of assets
and liabilities.
Net interest income grew 10.2% to $37.2 million during 1999. During 1998, net
interest income was $33.8 million representing an increase of 14.3% over 1997.
On a fully taxable equivalent basis, net interest income increased 9.5% and
totaled $38.9 million during 1999, compared to $35.5 million for 1998. In 1997,
on a taxable equivalent basis, net interest income declined 0.6% or $202
thousand from that of 1996. Net interest income on a taxable equivalent basis,
expressed as a percentage of average total earning assets, is referred to as the
net interest margin, which represents the average net effective yield on earning
assets. For 1999, the net interest margin was 5.31% compared to 5.46% in 1998.
The decrease in net interest margin was the result of the yields on average
earning assets declining at a greater rate than rates paid on interest bearing
deposits during 1999.
The predominant reasons for the growth in net interest income during 1999 was
the increase in the volume of average earning assets as well as the change in
the mix of asset totals and deposit balances. As a result of aggressive
marketing efforts and calling programs, average earning assets increased $82.4
million during 1999 while average interest bearing liabilities increased $60.1
million.
Loans, the Company's highest earning asset, increased $84.2 million as of
December 31, 1999 compared to 1998. On an average balance basis, loans
increased by $68.1 million during the year, which contributed to the
corresponding increase in interest and fees on loans of $4.9 million. The yield
on the loan portfolio was 9.5% in 1999 compared to 10.1% in 1998. The decrease
in loan yields during 1999 was the result of a lower interest rate environment
during the first two quarters of 1999 along with increased price competition for
new loans.
The investment portfolio represents a significant portion of the Company's
earning assets. The Company's investment policy is conservative. The Company
primarily invests in mortgage-backed securities, U.S. Treasuries, U.S.
Government Agencies, and high-grade municipals. Since the risk factor for these
types of investments is significantly lower than that of loans, the yield earned
on investments is substantially less than that of loans.
Average investment securities increased $16.3 million during 1999. This
resulted in growth in interest income on investment securities by $73 thousand.
The average yield, on a taxable equivalent basis, in the investment portfolio
was 6.32% in 1999 and 6.60% in 1998. The tax equivalent yield in 1997 was 6.8%.
The decrease in yield on the portfolio during 1999 and 1998 was due to the
relatively low interest rate environment in those years. Securities that
matured in 1999 were reinvested in securities with yields below those of the
maturing securities. Net interest
26
income on a taxable equivalent basis is higher than net interest income on the
Consolidated Statements of Income because it reflects adjustments that relate to
income on certain securities that are exempt from federal income taxes.
Interest expense increased as a result of an increase in deposit balances and a
general increase in interest rates (due to price competition and market rates)
during the second half of 1999. Due to several deposit gathering promotions and
the Company's prospect calling efforts, total deposits increased 9.2%. In
addition to the growth in interest bearing deposits, customers' time deposits
that matured during the year and were reinvested in higher yielding time
certificates. Accordingly, interest expense increased 8.2%. Average interest
cost on interest-bearing deposits declined to 3.3% in 1999, due to the growth in
low cost demand accounts along with a general decrease in market rates. Total
interest expense on deposit accounts for 1999 was $16.5 million. In 1998,
interest expense on deposits was $15.8 million. The average rate paid on
interest-bearing deposits was 3.30% in 1999 and 3.52% in 1998.
The Company's earning assets and rate sensitive liabilities are subject to
repricing at different times, which exposes the Company to income fluctuations
when interest rates change. In order to minimize income fluctuations, the
Company attempts to match asset and liability maturities. However, some
maturity mismatch is inherent in the asset and liability mix.
Provision and Reserve for Loan Losses
As a financial institution that assumes lending and credit risks as a principal
element of its business, the Company anticipates that credit losses will be
experienced in the normal course of business. The provision for loan losses
creates a reserve to absorb potential future losses. The reserve for loan
losses is maintained at a level considered by management to be adequate to
provide for risks inherent in the loan portfolio. In determining the adequacy
of the reserve for loan losses, management takes into consideration examinations
of bank supervisory authorities, results of internal credit reviews, financial
condition of borrowers, loan concentrations, prior loan loss experience, and
general economic conditions. The reserve is based on estimates and ultimate
future losses may vary from the current estimates. Management reviews these
estimates periodically and, when adjustments are necessary, they are reported in
the period in which they become known.
The Provision for Loan Losses totaled $1.7 million in 1999, compared to $1.4
million in 1998. The increase in the provision was the result of management's
evaluation of the credit quality of the loan portfolio, current loan losses, the
prevailing economic climate, and its effect on borrowers' ability to repay loans
in accordance with the terms of the notes. After reviewing all factors,
management concluded that an increase in the provision for loan losses was
appropriate.
As of December 31, 1999, the reserve for loan losses was $9.8 million, which
represented 2.4% of the total loan balance. In 1998, the reserve for loan
losses was $8.6 million or 2.6% of the total loan balance.
Non-Interest Income
Non-Interest income for the Company includes income derived from services
offered by the Bank, such as, merchant card, investment services and other
miscellaneous business services; it also includes service charges and fees from
deposit accounts and net gains and losses from the sale of investment securities
and other real estate owned.
Before securities transactions, non-interest income increased 8.6% in 1999 over
1998. Total non-interest income was $5.7 million, which included $302,000 in
security losses. The security losses were taken to restructure a portion of the
investment portfolio by replacing lower yielding investments with securities
with higher returns. In 1998, non-interest income was $5.8 million. In 1997,
the Company recorded $5.1 million of non-interest income.
Non-Interest Expense
Non-interest expense totaled $27.0 million during 1999, an increase of $926
thousand or 3.6% over that reported in 1998. The increase in 1998 over 1997 was
7.9% with total non-interest expense reported at $26.1 million.
Salaries and employee benefits, the largest component of non-interest expense,
increased $858 thousand in 1999, representing an increase of 5.9% over that of
1998. During 1998, the increase was $1.7 million or 13.1% over
27
1997. The increase was primarily the net result of merit increases for Company
employees and an increase in accrued performance bonuses. At the end of 1999,
the Company had 321.9 full time equivalent employees compared to 335.7 at the
end of 1998.
Occupancy expense declined 5.4% during 1999. Equipment expense increased $165
thousand or 7.9% and reached $2.3 million during 1999. These equipment
expenditures were for productivity enhancing computer equipment and in
preparation for being year 2000 compliant. During 1998, equipment expense
increased 7.5% or $147 thousand over the previous year. Other operating expense
totaled $7.7 million and remained unchanged from the prior year.
Income Taxes
The provision for income taxes increased 21.9% during 1999 as a result of
improved earnings. In 1998 the provision increased 292.4% due to the reversal
from declining earnings experienced in 1997. The effective tax rate in 1999 was
34.8% compared to 33.3% in 1998. The increase in the effective tax rate in 1999
was due to a decline in tax advantaged investment securities during the year.
Current tax law causes the Company's current taxes payable to approximate or
exceed the current provision for taxes on the income statement. Two provisions
have had a significant effect on the Company's current income tax liability; the
restrictions on the deductibility of loan losses and the mandatory use of
accrual accounting for taxes rather than the cash basis method of accounting.
Balance Sheet Analysis
Investment Securities
The Financial Accounting Standards Board statement, Accounting for Certain
Investments in Debt and Equity Securities, requires the Company to classify its
investments as held-to-maturity, trading or available- for-sale. As of December
31, the Company classified securities as either held-to-maturity or available-
for-sale. Trading securities are securities acquired for short-term
appreciation and are carried at fair value, with unrealized gains and losses
recorded in non-interest income. As of December 31, there were no securities in
the trading portfolio.
Securities are classified as held-to-maturity and accounted for at amortized
cost when the Company has the positive intent and ability to hold the securities
to maturity.
Securities for which the Company does not have the intent to hold to maturity
are classified as available-for-sale. This portion of the investment portfolio
provides the Company with liquidity that may be required to meet the needs of
Company borrowers and satisfy depositor's withdrawals.
The investment portfolio provides the Company with an income alternative to
loans. The Company's total investment portfolio represented 42% of the Company's
total assets during 1999 and 49% of the Company's total assets during 1998. Not
included in the investment portfolio are overnight investments in Federal Funds
Sold. In 1999, average Federal Funds Sold on a year to date basis was $15.6
million compared to $17.7 million in 1998.
The Company's investment portfolio at the end of 1999 decreased $25.6 million or
6.9% from 1998. The proceeds from the decline in the investment portfolio was
used to fund the Company's loan growth during 1999. On an average balance
basis, the Company increased its investment in Obligations of States and
Political Subdivisions (municipals) by $2.3 million. The Company generally
replaces maturities of municipal securities, to the point of a maximum tax
benefit, with "qualified issues." Qualified issues are municipal obligations
that are considered "small issues" and meet Internal Revenue Service
requirements. By meeting these requirements, the interest earned from qualified
issues is exempt from federal income taxes.
Note 3 in the Notes to Consolidated Financial Statements shows the
classifications of the Company's investment portfolio, the market value of the
Company's investment portfolio and the maturity distribution.
Loans
The Company's written lending policies, along with applicable laws and
regulations governing the extension of credit, require risk analysis as well as
ongoing portfolio and credit management through loan product
28
diversification, lending limits, ongoing credit reviews and approval policies
prior to funding of any loan. The Company manages and controls credit risk
through diversification, dollar limits on loans to one borrower and by primarily
restricting loans made to its principal market area. Loans that are performing
but have shown some signs of weakness are subjected to more stringent reporting
and oversight. Fixed-rate real estate loans are comprised primarily of loans
with maturities of less than five years. Long-term residential loans are
originated by the Company and sold in the secondary market.
As of December 31, 1999, loans increased $84.2 million, a 25.6% increase over
that of 1998. On an average balance basis the Company's loan portfolio
increased $68.1 million over the average balance in 1998. In 1998, average
balances increased from the prior year by 12.2% or $32.1 million. This increase
was due to strong loan demand in the Company's market area along with an
aggressive calling program.
Non-Performing Loans
The Company's policy is to place loans on non-accrual status when, for any
reason, principal or interest is past due for ninety days or more unless it is
both well secured and in the process of collection. Any interest accrued, but
unpaid, is reversed against current income. Thereafter, interest is recognized
as income only as it is collected in cash.
As a result of events beyond the Company's control, problem loans can and do
occur. As of December 31, 1999, non-accrual loans were $2.5 million compared
to $4.6 million at the end of 1998. Reducing problem loans continues to be an
important Company objective. The Company reported $204 thousand in foreclosed
loans as other real estate in 1999, compared to the $636 thousand reported in
1998. Interest forgone on loans placed on a non-accrual status totaled $48
thousand at December 31, 1999. The reduction in the non-accrual loans and other
real estate resulted from a focused effort to reduce problem assets.
Although management believes that non-performing loans are generally well
secured and that potential losses are provided for in the Company's reserve for
loan losses, there can be no assurance that future deterioration in economic
conditions or collateral values will not result in future credit losses.
Deposits
At December 31, 1999, deposits totaled $685.1 million. This represents an
increase of $57.8 million or 9.2% from the deposit totals of $627.4 million
reported in 1998. The majority of the increase was focused in interest-bearing
transaction and time deposits, which increased $10.9 million and $27.0 million,
respectively. The Company increased its marketing efforts for deposits during
1999 and ran several successful deposit campaigns contributing to the strong
growth in deposit balances. The change in the mix of deposits occurs as
interest rates change. The expectations our customers have of future interest
rates, dictates their maturity and account selections. As rates increased
during 1999, some customers locked in rates in anticipation of future declines
while other customers placed their funds in transaction accounts because they
anticipated rates would rise and were unwilling to commit their deposits to long
term investments at the current rates.
The most volatile deposits in any financial institution are certificates of
deposit over $100,000. The Company has not found its certificates of deposit
over $100,000 to be as volatile as some other financial institutions as it does
not solicit these types of deposits from brokers nor does it offer interest rate
premiums. It has been the Company's experience that large depositors have
placed their funds with the Company due to its strong reputation for safety,
security and liquidity.
Federal Home Loan Bank Advances
Advances from the Federal Home Loan Bank are used to match fund long-term real
estate loans and, as opportunities exist, the Bank borrows funds and invests the
proceeds at a positive spread through the investment portfolio. These
activities contribute to the Bank and Company's earnings as well as help offset
the Bank's interest rate risk. The average rate paid for other borrowed funds
was 5.42% in 1999 compared to 5.51% in 1998.
29
Capital
The Company relies on capital generated through the retention of earnings to
satisfy its capital requirements. The Company engages in an ongoing assessment
of its capital needs in order to support business growth and to insure depositor
protection. Shareholders' Equity totaled $80.2 million at December 31, 1999 and
$79.4 million at the end of 1998.
The Board of Governors of the Federal Reserve System and the Federal Deposit
Insurance Corporation have adopted risk-based capital guidelines. The
guidelines are designed to make capital requirements more sensitive to
differences in risk related assets among banking organizations, to take into
account off-balance sheet exposures and to aid in making the definition of bank
capital uniform. Company assets and off-balance sheet items are categorized by
risk. The results of these regulations are that assets with a higher degree of
risk require a larger amount of capital; assets, such as cash, with a low degree
of risk have little or no capital requirements. Under these guidelines the
Company is currently required to maintain regulatory risk based capital equal to
at least 8.0%.
As of December 31, 1999, the Company's risk based capital was 18.5%, well above
regulatory risk based capital guidelines.
In 1998, the Shareholders approved a stock repurchase program. During 1999, the
company repurchased 2,306 shares at an average share price of $175 per share.
In 1998, the Company repurchased 1,520 shares at an average share price of $150.
Risk Management
The Company has adopted a Risk Management Plan to ensure the proper control and
management of all risk factors inherent in the operation of the Company and the
Bank. Specifically, credit risk, interest rate risk, liquidity risk, compliance
risk, strategic risk, reputation risk and price risk can all affect the market
risk of the Company. These specific risk factors are not mutually exclusive.
It is recognized that any product or service offered by the Company may expose
the Company and Bank to one or more of these risk factors.
Credit Risk
Credit risk is the risk to earnings or capital arising from an obligor's failure
to meet the terms of any contract or otherwise fail to perform as agreed.
Credit risk is found in all activities where success depends on counterparty,
issuer, or borrower performance.
Central to the Company's credit risk management is a proven loan risk rating
system. Limitations on industry concentration, aggregate customer borrowings
and geographic boundaries also reduce loan credit risk. Credit risk in the
investment portfolio is minimized through clearly defined limits in the Bank's
policy statements. Senior Management, Directors' Committees, and the Board of
Directors are provided with timely and accurate information to appropriately
identify, measure, control and monitor the credit risk of the Company and the
Bank.
The reserve for loan losses is based on estimates of probable losses inherent in
the loan portfolio. The amount actually incurred with respect to these losses
can vary significantly from the estimated amounts. The Company's methodology
includes several features which are intended to reduce the difference between
estimated and actual losses.
Implicit in lending activities is the risk that losses will and do occur and
that the amount of such losses will vary over time. Consequently, the Company
maintains a reserve for loan losses by charging a provision for loan losses to
earnings. Loans determined to be losses are charged against the reserve for
loan losses. The Company's reserve for loan losses is maintained at a level
considered by management to be adequate to provide for estimated losses inherent
in the existing portfolio along with unused commitments to provide financing
including commitments under commercial and standby letters of credit.
The Company's methodology for assessing the appropriateness of the reserve
consists of several key elements, which include the formula allowance, specific
allowances for identified problem loans and portfolio segments and the
unallocated allowance. Specific allowances are established in cases where
management has identified
30
conditions or circumstances related to credit that management believes indicate
the possibility that a loss may be incurred in excess of the amount determined
by the application of the formula reserve. Management performs a detailed
analysis of these loans, including, but not limited to appraisals of the
collateral, conditions of the marketplace for liquidating the collateral and
assessment of the guarantors. Management then determines the loss potential and
allocates a portion of the reserve for losses as a specific allowance for each
of these credits.
Management believes that the allowance for loan losses at December 31, 1999 was
adequate to provide for both recognized and potential losses and estimated
inherent losses in the portfolio. No assurances can be given that future events
may not result in increases in delinquencies, non-performing loans or net loan
chargeoffs that would increase the provision for loan losses and thereby
adversely affect the results of operations.
Asset / Liability Management - Interest Rate Risk
The mismatch between maturities of interest sensitive assets and liabilities
results in uncertainty in the Company's earnings and economic value and is
referred to as interest rate risk. Farmers & Merchants Bancorp's primary
objective in managing interest rate risk is to minimize the potential for
significant loss as a result of changes in interest rates.
The Company measures interest rate risk in terms of potential impact on both its
economic value and earnings. The methods for governing the amount of interest
rate risk include: analysis of asset and liability mismatches (GAP analysis),
the utilization of a simulation model and limits on maturities of investment,
loan and deposit products to relatively short periods which reduces the market
volatility of those instruments.
The gap analysis measures, at specific time intervals, the divergence between
earning assets and interest bearing liabilities for which repricing
opportunities will occur. A positive difference, or gap, indicates that earning
assets will reprice faster than interest-bearing liabilities. This will
generally produce a greater net interest margin during periods of rising
interest rates, and a lower net interest margin during periods of declining
interest rates. Conversely, a negative gap will generally produce a lower net
interest margin during periods of rising interest rates and a greater net
interest margin during periods of decreasing interest rates.
The interest rates paid on deposit accounts do not always move in unison with
the rates charged on loans. In addition, the magnitude of changes in the rates
charged on loans is not always proportionate to the magnitude of changes in the
rate paid for deposits. Consequently, changes in interest rates do not
necessarily result in an increase or decrease in the net interest margin solely
as a result of the differences between repricing opportunities of earning assets
or interest bearing liabilities.
The Company also utilizes the results of a dynamic simulation model to quantify
the estimated exposure of net interest income to sustained interest rate
changes. The sensitivity of the Company's net interest income is measured over
a rolling one-year horizon.
The simulation model estimates the impact of changing interest rates on interest
income from all interest earning assets and the interest expense paid on all
interest bearing liabilities reflected on the Company's balance sheet. This
sensitivity analysis is compared to policy limits, which specify a maximum
tolerance level for net interest income exposure over a one-year horizon
assuming no balance sheet growth, given both a 200 basis point upward and
downward shift in interest rates. A parallel and pro rata shift in rates over a
12-month period is assumed. Results that exceed policy limits, if any, are
analyzed for risk tolerance and reported to the Board with appropriate
recommendations. At December 31, 1999, the Bank's estimated net interest income
sensitivity, as a percent of net interest income, for a parallel change in
interest rates of 200 basis points was 3.87% for rates up and (4.87)% in rates
down.
The estimated sensitivity does not necessarily represent a Company forecast and
the results may not be indicative of actual changes to the Company's net
interest income. These estimates are based upon a number of assumptions
including: the nature and timing of interest rate levels including yield curve
shape, prepayments on loans and securities, pricing strategies on loans and
deposits, replacement of asset and liability cashflows, and other assumptions.
While the assumptions used are based on current economic and local market
conditions, there is no
31
assurance as to the predictive nature of these conditions including how customer
preferences or competitor influences might change.
Liquidity
Liquidity risk is the risk to earnings or capital resulting from the Bank's
inability to meet its obligations when they come due without incurring
unacceptable losses. It includes the ability to manage unplanned decreases or
changes in funding sources and to recognize or address changes in market
conditions that affect the Bank's ability to liquidate assets or acquire funds
quickly and with minimum loss of value. The Company endeavors to maintain a
cash flow adequate to fund operations, handle fluctuations in deposit levels,
respond to the credit needs of borrowers and to take advantage of investment
opportunities as they arise. The principal sources of liquidity include
interest and principal payments on loans and investments, proceeds from the
maturity or sale of investments, and growth in deposits.
In general, liquidity risk is managed daily by controlling the level of Fed
Funds and the use of funds provided by the cash flow from the investment
portfolio. The Company maintains overnight investments in Fed Funds as a
cushion for temporary liquidity needs. During 1999, Federal Funds averaged
$15.6 million. In addition, the Company maintains Federal Fund credit lines of
$136 million with major correspondent banks subject to the customary terms and
conditions for such arrangements.
At December 31, 1999, the Company had available liquid assets, which included
cash and unpledged investment securities of approximately $339.6 million, which
represents 41.4% of total assets.
Year 2000 Update
The Company is pleased to report that its efforts to prepare for the year 2000
were completely successful. The following is a summary of the more relevant
facts:
. There were no system interruptions as a result of the date change.
. There are no further costs anticipated related to the year 2000.
. The costs to become compliant approximate the $1,571,000 previously reported.
. During the fourth quarter of 1999, there was no significant change in the
Company's revenue or spending patterns.
. The Company has not postponed any material project or capital improvements
due to the year 2000.
. The Company is not aware of any customer or third party vendor that will not
be able to perform in accordance with existing contracts or service
agreements.
32