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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[x] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1995
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from NA TO
Commission File Number 0-15982
(Exact name of registrant as
specified in its charter) NATIONAL MERCANTILE BANCORP
(State or other jurisdiction of
incorporation or organization) CALIFORNIA
(I.R.S. employer identification No.) 95-3819685
(Address of principal executive offices) 1840 CENTURY PARK EAST
LOS ANGELES, CALIFORNIA
(Zip code) 90067
Registrant's telephone number,
including area code: (310) 277-2265
Securities registered pursuant to
Section 12(b) of the Act: NONE
Securities registered pursuant to
Section 12(g) of the Act: COMMON STOCK, NO PAR VALUE
(TITLE OF CLASS)
Indicate by check mark whether the
registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d)
of the Securities Exchange Act of 1934
during the preceding 12 months
(or for such shorter period that the registrant
was required to file such reports), and
(2) has been subject to such filling requirements
for the past 90 days. YES 'X' NO
Indicate by check mark if disclosure
of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained
herein, and will not be contained, to the
best of registrant's knowledge, in
definitive proxy or information statements
incorporated by reference in Part III
of this Form 10-K [ ].
The aggregate market value of
the voting stock held by non-affiliates
of the registrant, based upon the
closing sale price of its Common Stock
as reported by the National Association
of Securities Dealers Automated Quotation System
on March 25, 1996, was approximately $6,048,696.
The number of shares of Common Stock,
no par value, of the registrant
outstanding as March 25, 1996 was 3,078,146.
DOCUMENTS INCORPORATED BY REFERENCE: NONE
This Report Includes a Total of 83 Pages
Index to Exhibits at Pages 82 to 83
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FORM 10-K
TABLE OF CONTENTS AND CROSS REFERENCE SHEET
Page(s) in
Form 10-K
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PART I
Item 1. Business 1
Item 2. Properties 13
Item 3. Legal Proceedings 14
Item 4. Submission of Matters to a Vote of Security Holders 15
PART II
Item 5. Market for the Registrant's Common Equity and Related Shareholder Matters 16
Item 6. Selected Financial Data 17
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 18
Item 8. Financial Statements 46
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 74
PART III
Item 10. Directors and Executive Officers of the Registrant 74
Item 11. Executive Compensation 76
Item 12. Security Ownership of Certain Beneficial Owners and Management 78
Item 13. Certain Relationships and Related Transactions 79
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K 80
Signatures 81
Index to Exhibits 82
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PART I
ITEM 1. BUSINESS
NATIONAL MERCANTILE BANCORP
National Mercantile Bancorp (the "Company") is a corporation which was organized
under the laws of the State of California on January 17, 1983 and is registered
as a bank holding company under the Bank Holding Company Act of 1956, as amended
(the "BHC Act"). The Company's principal asset is the capital stock of
Mercantile National Bank (the "Bank"), which became its wholly-owned subsidiary
on May 31, 1984.
The Company's principal business is to serve as a holding company for the Bank,
and for other banking or banking-related subsidiaries which the Company may
establish or acquire. On February 6, 1986, the Federal Reserve Bank of San
Francisco ("FRBSF") approved the Company to engage in lending activities. As a
legal entity separate and distinct from its subsidiary, the Company's principal
source of funds is, and will continue to be, dividends paid to the Company by
the Bank. Legal limitations are imposed on the amount of dividends that may be
paid and loans that may be made by the Bank to the Company (See Note 14 of the
accompanying notes to consolidated financial statements). In addition, the
Company entered into a Memorandum of Understanding with the FRBSF wherein the
Company agreed to not pay any dividends without the prior written approval of
the FRBSF. (See "Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS - "Capital Resources" and "Regulatory
Agreements.")
At December 31, 1995, the Company had total consolidated assets of $132.0
million.
MERCANTILE NATIONAL BANK
General
The Bank was organized on October 29, 1981, as a national banking association
and obtained a Certificate of Authority to commence the business of banking from
the Office of the Comptroller of the Currency (the "OCC") effective March 22,
1982. As a result of examinations conducted in 1995, the bank entered into a
formal regulatory agreement with the OCC on December 14, 1995 (the "Formal
Agreement") which supersedes and replaces a formal regulatory agreement entered
into by the Bank on July 26, 1991. For additional information concerning the
Amended Formal Agreement, see "Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- "Capital Resources" and
"Regulatory Agreements." See also "Cautionary Statement for Purposes of the
'Safe Harbor' Provisions of the Private Securities Litigation Reform Act."
The Bank seeks to distinguish itself from its larger and better known
competitors by providing a wide range of financial services to a limited number
of niche markets. These niche markets include the entertainment industry, the
technology market, the private banking market, business banking clients, Small
Business Administration clients, and escrow companies.
The Bank's business activities generate deposits and loans. The Bank provides
investment services as an added service to its client group. The Bank offers
investment services in conjunction with a third party broker dealer. On behalf
of the Bank, the third party broker dealer provides a range of investment
services, including mutual funds, annuities and certain insurance products. In
the entertainment segment, deposits are gathered by providing a high degree of
personalized service to the business and personal managers of high net worth
individuals associated with the industry. The Bank also makes loans to these
individuals and their affiliates or their business managers, and to independent
film production companies.
The Bank's private banking market and business banking markets also generate
both deposits and loans. The private banking activities focus on those companies
and individuals who provide business management services to high net worth
individuals, executives, professionals and entrepreneurs, including attorneys
and CPAs. Business banking focuses on professional firms, small service-oriented
companies, real estate investors and middle market companies.
The Bank is also expanding its focus on providing services to technology
companies which are primarily multi-media companies. The Bank considers this
industry group as a part of its existing niche markets and intends to continue
to provide a high level of service to clients in this industry.
The escrow company business is predominantly a deposit gathering function.
Deposits are received from these clients because of the Bank's ability to
provide a high degree of client service. Certain elements of this service are
delivered through third party
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vendors. The Bank controls the magnitude of these third party client service
expenses by continuously monitoring the profitability of its client
relationships through the means of a computerized analytic system. These
services and their underlying costs are limited by relationship profitability.
The Bank offers retail or consumer banking services primarily to the owners,
directors, officers and employees of its wholesale clients and the clients of
accounting and business management firms with which it regularly does business.
At December 31, 1995, the Bank had $132.0 million in assets, $78.2 million in
net loans and $120.3 million in total deposits.
Competition
The banking business in California generally, and in the Bank's primary service
areas specifically, is highly competitive with respect to both loans and
deposits, and is dominated by a relatively small number of major banks which
have many offices operating over a wide geographical area. The Bank competes for
loans and deposits primarily with other commercial banks, as well as with
non-bank financial institutions, and savings and loan associations, credit
unions, thrift and loan companies, mortgage companies, commercial finance
lenders, and providers of money market accounts. Among the advantages certain of
those institutions have over the Bank is their ability to finance wide-ranging
and effective advertising campaigns and to allocate their investment resources
to regions of highest yield and demand. In addition, many of the major
commercial banks operating in the Bank's primary service areas offer certain
services, such as trust services, which are not offered directly by the Bank
and, by virtue of their greater total capitalization, such banks have
substantially higher lending limits than the Bank.
To compete with other financial institutions in its primary service areas, the
Bank relies principally upon personal contact by its officers, directors and
employees and providing, through third parties, specialized services such as
messenger services and escrow accounting services. For clients whose loan
demands exceed the Bank's legal lending limits, the Bank has arranged for such
loans on a participation basis with other banks. The Bank also assists clients
requiring other services not offered by the Bank in obtaining such services from
other providers.
EFFECT OF GOVERNMENTAL POLICIES AND RECENT LEGISLATION
Government Fiscal and Monetary Policies
Banking is a business which depends in large part on rate differentials. In
general, the difference between the interest rate paid by the Bank on its
deposits and its other borrowings and the interest rate received by the Bank on
loans extended to its clients and securities held in the Bank's portfolio
comprise a major portion of the Company's earnings. These rates are highly
sensitive to many factors that are beyond the control of the Bank. Accordingly,
the earnings and growth of the Company are subject to the influence of domestic
and foreign economic conditions, including inflation, recession and
unemployment.
The commercial banking business is not only affected by general economic
conditions but is also influenced by the monetary and fiscal policies of the
federal government and the policies of regulatory agencies, particularly the
Board of Governors of the Federal Reserve System (the "Federal Reserve Board").
The Federal Reserve Board implements national monetary policies (with objectives
such as curbing inflation and combating recession) by its open-market operations
in United States Government securities, by adjusting the required level of
reserves for financial institutions subject to its reserve requirements and by
varying the discount rates applicable to borrowings by depository institutions.
The actions of the Federal Reserve Board in these areas influence the growth of
bank loans, investments and deposits and also affect interest rates charged on
loans and paid on deposits. The nature and impact of any future changes in
monetary policies cannot be predicted.
From time to time, legislation is enacted which has the effect of increasing the
cost of doing business, limiting or expanding permissible activities or
affecting the competitive balance between banks and other financial
institutions. Proposals to change the laws and regulations governing the
operations and taxation of banks, bank holding companies and other financial
institutions are frequently made in Congress, in the California legislature and
before various bank regulatory and other professional agencies. The likelihood
of any major changes and the impact such changes might have on the Company are
impossible to predict. Certain of the potentially significant changes which have
been enacted, and proposals which have been made recently, are discussed below.
Recent and proposed accounting changes are discussed in "Item 7. MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS."
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The following discussion of statutes and regulations is only a summary and does
not purport to be complete. This discussion is qualified in its entirety by
reference to such statutes and regulations. No assurance can be given that such
statutes or regulations will not change in the future.
Federal Deposit Insurance Corporation Improvement Act of 1991
On December 19, 1991, the Federal Deposit Insurance Corporation Improvement Act
of 1991 ("FDICIA") was enacted into law. Set forth below is a summary of certain
provisions of that law and actual and proposed enabling regulations.
Prompt Corrective Action. FDICIA requires each federal banking agency to take
prompt corrective action to resolve the problems of insured depository
institutions that fall below one or more prescribed minimum capital ratios. The
purpose of this law is to resolve the problems of insured depository
institutions at the least possible long-term cost to the appropriate deposit
insurance fund. The prompt corrective action provisions of FDICIA provide for
certain mandatory and discretionary actions by the appropriate federal banking
regulatory agency, determined mostly by an institution's ranking within the
following five capital measures: "well capitalized" (significantly exceeding the
required minimum capital requirements), "adequately capitalized" (meeting the
required capital requirements), "undercapitalized" (failing to meet any one of
the capital requirements), "significantly undercapitalized" (significantly below
any one capital requirement), and "critically undercapitalized" (failing to meet
all the capital requirements).
In December 1992, the federal banking agencies issued substantially uniform
final regulations implementing the prompt corrective provisions of FDICIA. Under
the regulations, an insured depository institution will be deemed to be:
(i) "well capitalized" if it has:
(a) a total risk-based capital ratio of 10% or greater,
(b) a Tier 1 risk-based capital ratio of 6% or greater,
(c) a leverage ratio of 5% or greater and
(d) is not subject to any written agreement, order, capital
directive or prompt corrective action directive to meet and maintain a
specific capital level for any capital measure;
(ii) "adequately capitalized" if it has:
(a) a total risk-based capital ratio of 8% or greater,
(b) a Tier 1 risk-based capital ratio of 4% or greater,
(c) a leverage ratio of 4% or greater (or a leverage ratio of 3% or
greater, if the institution receives the highest rating from its primary
regulator, and
(d) does not meet the definition of a well capitalized bank;
(iii) "undercapitalized" if it has:
(a) a total risk-based capital ratio of less than 8%,
(b) a Tier 1 risk-based capital ratio of less than 4% or
(c) a leverage ratio of less than 4% (or a leverage ratio of less
than 3%, if the institution receives the highest rating from its primary
regulator;
(iv) "significantly undercapitalized" if it has:
(a) a total risk-based capital ratio of less than 6%,
(b) a Tier 1 risk-based capital ratio of less than 3% or
(c) a leverage ratio of less than 3%; and
(v) "critically undercapitalized" if it has a ratio of tangible equity
to total assets equal to or less than 2%.
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The federal banking agencies may also, under certain circumstances, reclassify a
"well capitalized" institution as "adequately capitalized" or require an
"adequately capitalized" or "undercapitalized" institution to comply with
supervisory actions as if it were in the next lower capital category. The
federal banking agencies may take such action upon a showing that an institution
is in an unsafe or unsound condition or is engaged in an unsafe or unsound
practice (including failure to correct certain unsatisfactory examination
ratings). At each successive lower capital category, an insured depository
institution is subject to more restrictions. The federal banking agencies,
however, may not treat an institution as "critically undercapitalized" until its
capital ratio actually warrants such treatment.
Insured depository institutions are subject to certain incremental supervisory
restraints based on their actual or imputed ranking within the five capital
categories. All such institutions are prohibited from paying management fees to
controlling persons or, with certain limited exceptions, making a capital
distribution if, after such transaction, the institution would be
undercapitalized.
If an insured depository institution is undercapitalized, it will be closely
monitored by the appropriate federal banking agency, subject to asset growth
restrictions and required to obtain prior regulatory approval for acquisitions,
branching and engaging in new lines of business. Any undercapitalized depository
institution must submit an acceptable capital restoration plan to the
appropriate federal banking agency 45 days after becoming undercapitalized. The
appropriate federal banking agency cannot accept a capital plan unless, among
other things, it determines that the plan (i) specifies the steps the
institution will take to become adequately capitalized, (ii) is based on
realistic assumptions, and (iii) is likely to succeed in restoring the
depository institution's capital. In addition, each company controlling an
undercapitalized depository institution must guarantee that the institution will
comply with the capital plan until the depository institution has been
adequately capitalized on an average basis during each of four consecutive
calendar quarters and must otherwise provide adequate assurances of performance.
The aggregate liability of such guarantee is limited to the lesser of (x) an
amount equal to 5% of the depository institution's total assets at the time the
institution became undercapitalized or (y) the amount which is necessary to
bring the institution into compliance with all capital standards applicable to
such institution as of the time the institution fails to comply with its capital
restoration plan. Finally, the appropriate federal banking agency may impose any
of the additional restrictions or sanctions that it may impose on significantly
undercapitalized institutions if it determines that such action will further the
purpose of the prompt corrective action provisions.
Significantly or critically undercapitalized insured depository institutions and
undercapitalized insured depository institutions which fail to submit or, in a
material respect, fail to implement an acceptable capital restoration plan are
subject to one or more of the following additional regulatory actions (one or
more of which is mandatory): (i) forced sale of voting shares to raise capital,
or if grounds exist for conservatorship or receivership, a forced merger; (ii)
restrictions on affiliate transactions; (iii) limitations on interest rates paid
on deposits; (iv) restrictions on asset growth or required shrinkage; (v)
alteration or curtailment of activities determined by the regulators to pose
excessive risk to the institution; (vi) replacement of directors or senior
executive officers; (vii) prohibition on acceptance of correspondent bank
deposits; (viii) restrictions on capital distributions by the holding companies
of such institutions; (ix) forced divestiture of an institution's subsidiaries
or divestiture by a bank holding company of an institution or a financially
troubled nonbanking affiliate; or (x) other actions as determined by the
appropriate Federal regulators.
The appropriate federal banking agency has discretion to determine which of the
foregoing restrictions or sanctions it will seek to impose, it is required to
force a sale of voting shares or merger, impose restrictions on affiliate
transactions and impose restrictions on rates paid on deposits unless it
determines that such actions would not further the purpose of the prompt
corrective action provisions. In addition, without the prior written approval of
the appropriate federal banking agency, a significantly undercapitalized
institution may not pay any bonus to its senior executive officers or provide
compensation to any of them at a rate that exceeds such officer's average rate
of base compensation during the 12 calendar months preceding the month in which
the institution became undercapitalized.
Further restrictions and sanctions are required to be imposed on critically
undercapitalized insured depository institutions, including at a minimum,
prohibitions on the following activities without the appropriate Federal
regulators' prior written consent: (i) entering into material transactions other
than in the usual course of business; (ii) extending credit for highly leveraged
transactions; (iii) amending an institution's charter or bylaws; (iv) making a
material change in accounting methods; (v) engaging in certain transactions with
affiliates; (vi) paying excessive compensation or bonuses; or (vii) paying rates
on new or renewed liabilities significantly in excess of market rates.
Additionally, sixty days after becoming critically undercapitalized, an
institution may not make payments of interest or principal on subordinated debt
without the permission of the FDIC and its
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primary federal regulator. Most importantly, however, except under limited
circumstances, the appropriate Federal banking agency, not later than 90 days
after an insured depository institution becomes critically undercapitalized, is
required to appoint a conservator or receiver for the institution. The board of
directors of an insured depository institution would not be liable to the
institution's shareholders or creditors for consenting in good faith to the
appointment of a receiver or conservator or to an acquisition or merger as
requested by the regulator.
In addition to measures taken under the prompt corrective action provisions,
commercial banking organizations may be subject to potential enforcement actions
by the federal regulators for unsafe or unsound practices in conducting their
businesses or for violations of any law, rule, regulation or any condition
imposed in writing by the agency or any written agreement with the agency.
Enforcement actions may include the imposition of a conservator or receiver, the
issuance of a cease and desist order that can be judicially enforced, the
termination of insurance of deposits (in the case of a depository institution),
the imposition of civil money penalties, the issuance of directives to increase
capital, the issuance of formal and informal agreements, the issuance of removal
and prohibition orders against institution-affiliated parties and the
enforcement of such actions through injunctions or restraining orders based upon
a judicial determination that the agency would be harmed if such equitable
relief was not granted.
As of December 31, 1995, the Company and Bank were deemed to be adequately
capitalized based upon their capital ratios, however, the Bank was not in
compliance with the total risk based capital ratio and the capital leverage
ratio required in the Amended Formal Agreement. (See "Item 7. MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS" and
"Regulatory Agreements.") Under the prompt corrective action provisions of the
FDICIA, a subsequent reduction in capital could cause the Company and the Bank
to fall within a lower capital category and subject them to the mandatory and
discretionary sanctions applicable to that category. Further, as noted above, an
institution that, based upon its capital levels, is adequately capitalized or
undercapitalized can, under certain circumstances, be reclassified to the next
lower capital category.
Rules Governing Insiders. FDICIA restates and enhances the scope of the Federal
Reserve Act limitations of extensions of credit to officers, directors, and
principal shareholders of member banks. Significantly, FDICIA expands the scope
of the Federal Reserve Act restrictions to include all state nonmember banks.
Under FDICIA, insider loan limitations applicable to banks also will be made
applicable to their subsidiaries. FDICIA also provides that the total of all
extensions of credit by an institution to all insiders and related interests may
not exceed the bank's unimpaired capital and unimpaired surplus. FDICIA empowers
the Federal Reserve Board to impose more stringent limitations on such loans.
Extensions of credit that were valid on the date of this provision's enactment
will not be affected.
Standards for Safety and Soundness. FDICIA requires that each federal banking
agency promulgate regulations setting forth certain safety and soundness
standards for insured depository institutions and, in some cases, their holding
companies relating to internal controls and audits, loan documentation, credit
underwriting, interest rate risk and asset growth. Standards also must be
prescribed for classified earnings and the ratio of market value to book value
for publicly traded shares. Further, FDICIA requires the federal banking
agencies to establish standards prohibiting compensation, fees and benefit
arrangements that are excessive or could lead to financial loss. Institutions or
holding companies failing to meet the prescribed standards will be required to
submit a plan to correct any deficiencies. FDICIA provides for certain mandatory
and discretionary sanctions for failing to submit or implement such a plan,
including asset growth limits, capital directives and deposit interest rate
ceilings.
Pursuant to FDICIA, the federal banking agencies have issued final guidelines
establishing standards for safety and soundness on matters such as loan
underwriting and documentation, asset quality, earnings, internal controls and
audit systems, interest rate risk exposure and compensation and other employee
benefits. Among other things, establish the maximum ratio of classified assets
to total capital at 1% and the minimum level of earnings sufficient to absorb
losses without impairing capital. The standards provide that a bank's earnings
are sufficient to absorb losses without impairing capital if the bank is in
compliance with minimum capital requirements and the bank would, if its net
income or loss over the last four quarters continued over the next four
quarters, remain in compliance with minimum capital requirements. Any
institution which fails to comply with these standards must submit a compliance
plan. Failure to submit a plan or to comply with an approved plan will subject
the institution to further enforcement action.
Real Estate Lending Standards. Pursuant to authority contained in FDICIA, the
federal banking agencies adopted final regulations which were effective March
19, 1993, which require insured depository institutions to establish and
maintain written internal real estate lending policies. These policies must be
consistent with safe and sound banking practices and be appropriate for the size
and nature of the institution involved. Additionally, they must be established
by each institution only
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after it has considered the Interagency Guidelines for Real Estate Lending
Policies, which are made a part of the final regulations. The regulations
require that certain specific standards be addressed relating to loan portfolio
diversification standards, prudent underwriting standards (including
loan-to-value limits), loan administration procedures, and documentation,
approval and reporting requirements. Each institution's lending policies must be
reviewed and approved by the institution's board of directors at least once a
year. Finally, each institution is expected to monitor conditions in its real
estate market to ensure that its lending policies are appropriate for current
market conditions. The regulations do not set forth specific loan-to-value
limits, but the Interagency Guidelines do provide certain limits which should
not be exceeded except under limited circumstances.
Appraisals for "real estate related financial transactions" must be conducted by
either state certified or state licensed appraisers for transactions in excess
of certain amounts. State certified appraisers are required for all transactions
with a transaction value of $1,000,000 or more; for all nonresidential
transactions valued at $250,000 or more; and for "complex" 1-4 family
residential properties of $250,000 or more. A state licensed appraiser is
required for all other appraisals. However, appraisals performed in connection
with "federally related transactions" must now comply with the agencies'
appraisal standards. Federally related transactions include the sale, lease,
purchase, investment in, or exchange of, real property or interests in real
property, the financing or refinancing of real property, and the use of real
property or interests in real property as security for a loan or investment,
including mortgage-backed securities.
Deposit Insurance Assessments. Federal law has established several mechanisms to
increase funds to protect deposits insured by the Bank Insurance Fund ("BIF")
administered by the FDIC. The FDIC is authorized to borrow up to $30 billion
from the United States Treasury; up to 90% of the fair market value of assets of
institutions acquired by the FDIC as receiver from the Federal Financing Bank;
and from depository institutions that are members of the BIF. Any borrowings not
repaid by asset sales are to be repaid through insurance premiums assessed to
member institutions. Such premiums must be sufficient to repay any borrowed
funds within 15 years and provide insurance fund reserves of $1.25 for each $100
of insured deposits. The result of these provisions is that the assessment rate
on deposits of BIF members could increase in the future. The FDIC also has
authority to impose special assessments against insured deposits.
The FDIC implemented a final risk-based assessment system, as required by
FDICIA, effective January 1, 1994, under which an institution's premium
assessment is based on the probability that the deposit insurance fund will
incur a loss with respect to the institution, the likely amount of any such
loss, and the revenue needs of the deposit insurance fund. As long as BIF's
reserve ratio is less than a specified "designated reserve ratio," 1.25%, the
total amount raised from BIF members by the risk-based assessment system may not
be less than the amount that would be raised if the assessment rate for all BIF
members were .023% of deposits. On August 8, 1995, the FDIC announced that the
designated reserve ratio had been achieved and, accordingly, issued final
regulations adopting an assessment rate schedule for BIF members of 4 to 31
basis points effective on June 1, 1995. On November 14, 1995, the FDIC further
reduced deposit insurance premiums to a range of 0 to 27 basis points effective
for the semi-annual period beginning January 1, 1996.
Under the risk-based assessment system, a BIF member institution such as the
Bank is categorized into one of three capital categories (well capitalized,
adequately capitalized, and undercapitalized) and one of three categories based
on supervisory evaluations by its primary federal regulator (in the Bank's case,
the FDIC). The three supervisory categories are: financially sound with only a
few minor weaknesses (Group A), demonstrates weaknesses that could result in
significant deterioration (Group B), and poses a substantial probability of loss
(Group C). The capital ratios used by the FDIC to define well-capitalized,
adequately capitalized and undercapitalized are the same in the FDIC's prompt
corrective action regulations. The BIF assessment rates are summarized below;
assessment figures are expressed in terms of cents per $100 in deposits.
Assessment Rates Effective Through the First Half of 1995
GROUP A GROUP B GROUP C
------- ------- -------
Well Capitalized.................................................... 23 26 29
Adequately Capitalized.............................................. 26 29 30
Undercapitalized.................................................... 29 30 31
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Assessment Rates Effective through the Second Half of 1995
GROUP A GROUP B GROUP C
------- ------- -------
Well Capitalized.................................................... 4 7 21
Adequately Capitalized.............................................. 7 14 28
Undercapitalized.................................................... 14 28 31
Assessment Rates Effective January 1, 1996
GROUP A GROUP B GROUP C
------- ------- -------
Well Capitalized.................................................... 0* 3 17
Adequately Capitalized.............................................. 3 10 24
Undercapitalized.................................................... 10 24 27
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* Subject to a statutory minimum assessment of $1,000 per semi-annual period
(which also applies to all other assessment risk classifications).
A number of proposals have recently been introduced in Congress to address the
disparity in bank and thrift deposit insurance premiums. On September 19, 1995,
legislation was introduced and referred to the House Banking Committee that
would, among other things: (i) impose a requirement on all SAIF member
institutions to fully recapitalize the SAIF by paying a one-time special
assessment of approximately 85 basis points on all assessable deposits as of
March 31, 1995, which assessment would be due as of January 1, 1996; (ii) spread
the responsibility for FICO interest payments across all FDIC-insured
institutions on a pro-rata basis, subject to certain exceptions; (iii) require
that deposit insurance premium assessment rates applicable to SAIF member
institutions be no less than deposit insurance premium assessment rates
applicable to BIF member institutions; (iv) provide for a merger of the BIF and
the SAIF as of January 1, 1998; (v) require savings associations to convert to
state or national bank charters by January 1, 1998; (vi) require savings
associations to divest any activities not permissible for commercial banks
within five years; (vii) eliminate the bad-debt reserve deduction for savings
associations, although savings associations would not be required to recapture
into income their accumulated bad-debt reserves; (viii) provide for the
conversion of savings and loan holding companies into bank holding companies as
of January 1, 1998, although unitary savings and loan holding companies
authorized to engage in activities as of September 13, 1995 would have such
authority grandfathered (subject to certain limitations); and (ix) abolish the
OTS and transfer the OTS' regulatory authority to the other federal banking
agencies. The legislation would also provide that any savings association that
would become undercapitalized under the prompt corrective action regulations as
a result of the special deposit premium assessment could be exempted from
payment of the assessment, provided that the institution would continue to be
subject to the payment of semiannual assessments under the current rate schedule
following the recapitalization of the SAIF. The legislation was considered and
passed by the House Banking Committee's Subcommittee on Financial Institutions
on September 27, 1995, and has not yet been acted on by the full House Banking
Committee.
On September 20, 1995, similar legislation was introduced in the Senate,
although the Senate bill does not include a comprehensive approach for merging
the savings association and commercial bank charters. The Senate bill remains
pending before the Senate Banking Committee.
The future of both these bills is linked with that of pending budget
reconciliation legislation since some of the major features of the bills are
included in the Seven-Year Balanced Budget Reconciliation Act. The budget bill,
which was passed by both the House and Senate on November 17, 1995 and vetoed by
the President on December 6, 1995, would: (i) recapitalize the SAIF through a
special assessment of between 70 and 80 basis points on deposits held by
institutions as of March 31, 1995; (ii) provide an exemption to this rule for
weak institutions, and a 20% reduction in the SAIF-assessable deposits of
so-called "Oakar banks;" (iii) expand the assessment base for FICO payments to
include all FDIC-insured institutions; (iv) merge the BIF and SAIF on January 1,
1998, only if no insured depository institution is a savings association on that
date; (v) establish a special reserve for the SAIF on January 1, 1998; and (vi)
prohibit the FDIC from setting semiannual assessments in excess of the amount
needed to maintain the reserve ratio of any fund at the designated reserve
ratio. The bill does not include a provision to merge the charters of savings
associations and commercial banks.
In light of ongoing debate over the content and fate of the budget bill, the
different proposals currently under consideration and the uncertainty of the
Congressional budget and legislative processes in general, Management cannot
predict whether any or all
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of the proposed legislation will be passed, or in what form. Accordingly, the
effect of any such legislation on the Bank cannot be determined.
The Bank's annual assessment rate for 1995 was 29 cents for every $100 of
deposits for the first nine months and 21 cents for the last three months. The
Bank's annual assessment rate for the first six months of 1996 will be 17 cents.
Improved Examinations. All insured depository institutions must undergo a
full-scope, on-site examination by their appropriate federal banking agency at
least once every 12 months. The cost of examinations of insured depository
institutions and any affiliates may be assessed by the appropriate federal
banking agency against each institution or affiliate as it deems necessary or
appropriate.
Other Items. FDICIA also, among other things, (i) limits the percentage of
interest paid on brokered deposits and limits the unrestricted use of such
deposits to only those institutions that are well capitalized; (ii) eliminates
"pass through" deposit insurance for certain employee benefit accounts unless
the depository institution is well capitalized or, under certain circumstances,
adequately capitalized; and (iii) provides that, subject to certain limitations,
any federal savings association may acquire or be acquired by any insured
depository institution.
Interstate Banking
In September 1994, the Riegel-Neal Interstate Banking and Branching Efficiency
Act of 1995 (the "Interstate Act") became law. Under the Interstate Act,
beginning one year after the date of enactment, a bank holding company that is
adequately capitalized and managed may obtain approval under the BHC Act to
acquire an existing bank located in another state without regard to state law.
A bank holding company would not be permitted to make such an acquisition if,
upon consummation, it would control (a) more than 10% of the total amount of
deposits of insured depository institutions in the United States or (b) 30% or
more of the deposits in the state in which the bank is located. A state may
limit the percentage of total deposits that may be held in that state by any one
bank or bank holding company if application of such limitation does not
discriminate against out-of-state banks. An out-of-state bank holding company
may not acquire a state bank in existence for less than a minimum length of time
that may be prescribed by state law except that a state may not impose more than
a five year existence requirement.
The Interstate Act also permits, beginning June 1, 1997, mergers of insured
banks located in different states and conversion of the branches of the acquired
bank into branches of the resulting bank. Each state may permit such
combinations earlier than June 1, 1997, and may adopt legislation to prohibit
interstate mergers after that date in that state or in other states by that
state's banks. The same concentration limits discussed in the preceding
paragraph apply. The Interstate Act also permits a national or state bank to
establish branches in a state other than its home state if permitted by the laws
of that state, subject to the same requirements and conditions as for a merger
transaction.
In October 1995, California adopted "opt in" legislation under the Interstate
Act that permits out-of-state banks to acquire California banks that satisfy a
five-year minimum age requirement (subject to exceptions for supervisory
transactions) by means of merger or purchases of assets, although entry through
acquisition of individual branches of California institutions and de novo
branching into California are not permitted. The Interstate Act and the
California branching statute will likely increase competition from out-of-state
banks in the markets in which the Company operates, although it is difficult to
assess the impact that such increased competition may have on the Company's
operations.
Capital Adequacy Guidelines
The Federal Reserve Board and the OCC have issued guidelines for risk-based
capital requirements. The guidelines provide a systematic analytical framework
that makes regulatory capital requirements more sensitive to differences in risk
profiles among banking organizations, takes off-balance sheet items into account
in assessing capital adequacy, and minimizes disincentives to holding liquid,
low-risk assets. Under these guidelines, assets and credit equivalent amounts of
off-balance sheet items, such as letters of credit and outstanding loan
commitments are assigned to one of several risk categories, which range from 0%
for risk-free assets, such as cash and certain U.S. government securities, to
100% for relatively high-risk assets, such as loans and investments in fixed
assets, premises and other real estate owned. The aggregated dollar amount of
each category is then multiplied by the risk weight associated with that
category. The resulting weighted values from each of the risk categories are
then added together to determine the amount of total risk-weighted assets. (See
"Item 1. Business -- Effect of Governmental
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Policies and Recent Legislation -- Federal Deposit Insurance Corporation
Improvement Act of 1991 -- Prompt Corrective Action," herein.)
A banking organization's qualifying total capital consists of two components:
Tier 1 Capital (Core Capital) and Tier 2 Capital (Supplementary Capital). Tier 1
Capital consists primarily of common stock, retained earnings, non-cumulative
perpetual preferred stock (cumulative perpetual preferred stock for bank holding
companies) and minority interests in certain subsidiaries less most intangible
assets, such as goodwill. At least 50% of a banking organization's total
regulatory capital must consist of Tier 1 Capital.
Tier 2 Capital may consist of (i) the allowance for possible loan and lease
losses in an amount up to 1.25% of risk-weighted assets; (ii) cumulative
preferred stock and long-term preferred stock (which for bank holding companies
must have an original maturity of 20 years or more) and related surplus; (iii)
hybrid capital instruments (instruments with characteristics of both debt and
equity), perpetual debt and mandatory convertible debt securities; and (iv)
eligible term subordinated debt and intermediate-term preferred stock with an
original maturity of five years or more, including related surplus, in an amount
up to 50% of Tier 1 Capital. The inclusion of the foregoing elements of Tier 2
Capital is subject to certain requirements and limitations of the federal
banking agencies.
In addition to the risk-based guidelines, the Federal Reserve Board and the OCC
require banking organizations to maintain a minimum amount of Tier 1 capital to
total assets, referred to as the leverage ratio. For a banking organization
rated in the highest of the five categories used by regulators to rate banking
organizations, the minimum leverage ratio of Tier 1 capital to total assets is
3%. For all banking organizations not rated in the highest category, the minimum
leverage ratio must be at least 100 to 200 basis points above the 3% minimum, or
4% to 5%. In addition to these uniform risk-based capital guidelines and
leverage ratios that apply across the industry, the regulators have the
discretion to set individual minimum capital requirements for specific
institutions at rates significantly above the minimum guidelines and ratios.
The Federal Reserve Board and the OCC require a minimum ratio of qualifying
total capital to risk-adjusted assets of 8% and a minimum ratio of Tier 1
capital to risk-adjusted assets of 4%. The leverage ratio is only a minimum.
Institutions experiencing or anticipating significant growth or those with other
than minimum risk profiles will be expected to maintain capital well above the
minimum levels.
Under the so-called "prompt corrective action" provisions of FDICIA and the
regulations promulgated thereunder, the Bank will be considered "adequately
capitalized" if it has a ratio of qualifying total capital to risk-weighted
assets of 8%, Tier 1 Capital to risk-weighted assets of 4% and a leverage ratio
of 4% or greater. To be considered "well capitalized" the Company and the Bank
must have a ratio of qualifying total capital to risk-weighted assets of 10%,
Tier 1 Capital to risk-weighted assets of 6% and a leverage ratio of 5% or
greater as well as not be subject to any order or directive. Under certain
circumstances, the Federal Reserve Board or the OCC may require an "adequately
capitalized" institution to comply with certain mandatory or discretionary
supervisory actions as if the Company or the Bank were undercapitalized. (See
"Item 1. BUSINESS -- Effect of Governmental Policies and Recent
Legislation -- Federal Deposit Insurance Corporation Improvement Act of
1991 -- Prompt Corrective Action.") Although the Company and the Bank are each
considered to be adequately capitalized, in accordance with the Amended Formal
Agreement, the Bank must maintain a minimum ratio of Tier 1 capital to risk
weighted assets of 10% and a minimum leverage ratio of 6.5%. At December 31,
1995, the Bank's Tier 1 capital to risk weighted assets ratio was 6.95% and the
capital leverage ratio was 4.67%, both of which were not in compliance with the
Amended Formal Agreement. A Capital Plan was filed with the OCC on February 8,
1996. (See "Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS" and "Regulatory Agreements.")
In August 1995, the federal banking agencies adopted final regulations
specifying that the agencies will include, in their evaluations of a bank's
capital adequacy, an assessment of the exposure to declines in the economic
value of the bank's capital due to changes in interest rates. The final
regulations, however, do not include a measurement framework for assessing the
level of a bank's exposure to interest rate risk, which is the subject of a
proposed policy statement issued by the federal banking agencies concurrently
with the final regulations. The proposal would measure interest rate risk in
relation to the effect of a 200 basis point change in market interest rates on
the economic value of a bank. Banks with high levels of measured exposure or
weak management systems generally will be required to hold additional capital
for interest rate risk. The specific amount of capital that may be needed would
be determined on a case-by-case basis by the examiner and the appropriate
federal banking agency. Because this proposal has only recently been issued, the
Company currently is unable to predict the impact of the proposal on the Bank if
the policy statement is adopted as proposed.
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In January 1995, the federal banking agencies issued a final rule relating to
capital standards and the risks arising from the concentration of credit and
nontraditional activities. Institutions which have significant amounts of their
assets concentrated in high risk loans or nontraditional banking activities and
who fail to adequately manage these risks, will be required to set aside capital
in excess of the regulatory minimums. The federal banking agencies have not
imposed any quantitative assessment for determining when these risks are
significant, but have identified these issues as important factors they will
review in assessing an individual bank's capital adequacy.
In December 1993, the federal banking agencies issued an interagency policy
statement on the allowance for loan and lease losses which, among other things,
establishes certain benchmark ratios of loan loss reserves to classified assets.
The benchmark set forth by such policy statement is the sum of (i) assets
classified loss; (ii) 50 percent of assets classified doubtful; (iii) 15 percent
of assets classified substandard; and (iv) estimated credit losses on other
assets over the upcoming 12 months.
Federally supervised banks and savings associations are currently required to
report deferred tax assets in accordance with SFAS No. 109. The federal banking
agencies recently issued final rules, effective April 1, 1995, which limit the
amount of deferred tax assets that are allowable in computing an institution's
regulatory capital. The standard has been in effect on an interim basis since
March 1993. Deferred tax assets that can be realized for taxes paid in prior
carryback years and from future reversals of existing taxable temporary
differences are generally not limited. Deferred tax assets that can only be
realized through future taxable earnings are limited for regulatory capital
purposes to the lesser of (i) the amount that can be realized within one year of
the quarter-end report date, or (ii) 10% of Tier 1 Capital. The amount of any
deferred tax in excess of this limit would be excluded from Tier 1 Capital and
total assets and regulatory capital calculations.
SUPERVISION AND REGULATION
The Company
The Company, as a registered bank holding company, is subject to regulation
under the BHC Act, and as such, is required to file with the Federal Reserve
Board quarterly and annual reports and such additional information as the
Federal Reserve Board may require pursuant to the BHC Act. The Federal Reserve
Board may conduct examinations of the Company and its subsidiaries. As a result
of such examinations of the Company by the Federal Reserve Board, the Company
entered into a Memorandum of Understanding with the Federal Reserve Board on
October 26, 1995 (the "Memorandum") which replaced a previous Memorandum of
Understanding dated October 25, 1991. The Memorandum imposes certain affirmative
obligations and material restrictions on the Company which will most likely
impede asset growth and preclude dividend payments in the foreseeable future or
until the Memorandum is revised or released. (See "Item 7. MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS -- Regulatory Agreements.")
The Federal Reserve Board may require that the Company terminate an activity or
control of certain subsidiaries or affiliates when the Federal Reserve Board
believes the activity or the control of the subsidiary or affiliate constitutes
a serious risk to the financial safety, soundness or stability of any of its
banking subsidiaries and is inconsistent with sound banking principles or the
purposes of the BHC Act or the Financial Institutions Supervisory Act of 1966,
as amended. The Federal Reserve Board also has the authority to regulate
provisions of certain bank holding company debt, including authority to impose
interest ceilings and reserve requirements on such debt. Under certain
circumstances, the Company must file written notice and obtain approval from the
Federal Reserve Board prior to purchasing or redeeming its equity securities.
Under the BHC Act and regulations adopted by the Federal Reserve Board, a bank
holding company and its nonbanking subsidiaries are prohibited from requiring
certain tie-in arrangements in connection with any extension of credit, lease or
sale of property or furnishing of services. Further, the Company is required by
the Federal Reserve Board to maintain certain levels of capital. The Federal
Reserve Board's risk-based capital guidelines establish a minimum level of
qualifying total capital to risk-weighted assets of 8% (of which at least 4%
should be in the form of Tier 1 Capital). The regulations set forth minimum
requirements, and the Federal Reserve Board has reserved the right to require
that companies maintain higher capital ratios. As of December 31, 1995, the
Company had a ratio of qualifying total capital to risk-weighted assets of
8.25%, of which 6.96% was in the form of Tier 1 Capital. Additionally, the
Federal Reserve Board has established a minimum leverage ratio for the Company
of 4%. As of December 31, 1995, the Company had a leverage ratio of 4.68%. For a
more complete description of the Federal Reserve Board's risk-based and leverage
capital guidelines, see "Item 1. BUSINESS -- Effect of Governmental Policies and
Recent Legislation -- Capital Adequacy Guidelines."
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The Company is required to obtain the prior approval of the Federal Reserve
Board for the acquisition of more than 5% of the outstanding shares of any class
of voting securities or substantially all of the assets of any bank or bank
holding company. Prior approval of the Federal Reserve Board is also required
for the merger or consolidation of the Company and another bank holding company.
As a result of an examination by Federal Reserve Bank of San Francisco
("FRBSF"), as of June 30, 1993, the FRBSF reviews new appointments of senior
executive officers and directors prior to their appointment to such a position.
The Company is prohibited by the BHC Act, except in certain statutory prescribed
instances, from acquiring direct or indirect ownership or control of more than
5% of the outstanding voting shares of any company that is not a bank or bank
holding company and from engaging directly or indirectly in activities other
than those of banking, managing or controlling banks or furnishing services to
its subsidiaries. However, the Company may, subject to the prior approval of the
Federal Reserve Board, engage in any, or acquire shares of companies engaged in,
activities that are deemed by the Federal Reserve Board to be so closely related
to banking or managing or controlling banks as to be a proper incident thereto.
In making any such determination, the Federal Reserve Board is required to
consider whether the performance of such activities by the Company or an
affiliate can reasonably be expected to produce benefits to the public, such as
greater convenience, increased competition or gains in efficiency, that outweigh
possible adverse effects, such as undue concentration of resources, decreased or
unfair competition, conflicts of interest or unsound banking practices. The
Federal Reserve Board is also empowered to differentiate between activities
commenced de novo and activities commenced by acquisition, in whole or in part,
of a going concern.
Under Federal Reserve Board regulations, a bank holding company is required to
serve as a source of financial and managerial strength to its subsidiary banks
and may not conduct its operations in an unsafe or unsound manner. In addition,
it is the Federal Reserve Board's policy that in serving as a source of strength
to its subsidiary banks, a bank holding company should stand ready to use
available resources to provide adequate capital funds to its subsidiary banks
during periods of financial stress or adversity and should maintain the
financial flexibility and capital-raising capacity to obtain additional
resources for assisting its subsidiary banks. A bank holding company's failure
to meet its obligations to serve as a source of strength to its subsidiary banks
will generally be considered by the Federal Reserve Board to be an unsafe and
unsound banking practice or a violation of the Federal Reserve Board's
regulations or both. This doctrine has become known as the "source of strength"
doctrine. Although the United States Court of Appeals for the Fifth Circuit
found the Federal Reserve Board's source of strength doctrine invalid in 1990,
stating that the Federal Reserve Board had no authority to assert the doctrine
under the BHC Act, the decision, which is not binding on federal courts outside
the Fifth Circuit, was recently reversed by the United States Supreme Court on
procedural grounds. The validity of the source of strength doctrine is likely to
continue to be the subject of litigation until definitively resolved by the
courts or by Congress.
The Company is also a bank holding company within the meaning of Section 3700 of
the California Financial Code. As such, the Company and its subsidiaries are
subject to examination by, and may be required to file reports with, the
California State Banking Department. Regulations have not been adopted to
implement the powers of the California Superintendent of Banks under this
statute.
Finally, the Company's shares of Common Stock are registered pursuant to the
Securities Exchange Act of 1934 (the "Exchange Act"). Accordingly, the Company
is subject to the rules and regulations promulgated by the Securities and
Exchange Commission (the "Commission"), including, among other things, the
periodic reporting requirements, the proxy rules and the short-swing profit
rules under Sections 13, 14 and 16 of the Exchange Act, respectively.
The Bank
The Bank, as a national banking association, is subject to primary supervision,
periodic examination and regulation by the OCC. If, as a result of an
examination of a bank, the OCC should determine that the financial condition,
capital resources, asset quality, earnings prospects, management, liquidity, or
other aspects of the Bank's operations are below levels determined to be
appropriate or that the Bank or its management are violating or has violated any
law or regulation, various remedies are available to the OCC. Such remedies
include the power to enjoin "unsafe or unsound" practices, to require
affirmative action to correct any conditions resulting from any violation or
practice, to issue an administrative order that can be judicially enforced, to
direct an increase in capital, to restrict the growth of the Bank, to assess
civil monetary penalties and to remove officers and directors. The FDIC has
similar enforcement authority, in addition to its authority to terminate the
Bank's deposit insurance in the absence of action by the OCC and upon a finding
that the Bank is in an unsafe or unsound condition, is engaging in unsafe or
unsound activities, or that its conduct poses a risk to the deposit insurance
fund or may prejudice the interest of its
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depositors. The Bank entered into a Formal Agreement with the OCC dated December
14, 1995, which imposes certain affirmative obligations and material
restrictions on the Bank. (For additional information concerning the Formal
Agreement, see "Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS -- "Capital Resources" and "Regulatory
Agreements.")
The Bank is insured by the FDIC, which currently insures deposits of each member
bank to a maximum of $100,000 per depositor. For this protection, each bank pays
a semi-annual statutory assessment and is subject to certain of the rules and
regulations of the FDIC. (See "Item 1. BUSINESS -- Effect of Governmental
Policies and Recent Legislation -- Federal Deposit Insurance Corporation
Improvement Act of 1991 -- Deposit Insurance Assessments.") The Bank also is
subject to certain regulations of the Federal Reserve Board.
Various requirements and restrictions under the laws of the State of California
and the United States affect the operations of the Bank. (See "Item 1.
BUSINESS -- Effect of Governmental Policies and Recent Legislation.") State and
federal statutes and regulations relate to many aspects of the Bank's
operations, including reserves against deposits, interest rates payable on
deposits, loans, investments, mergers and acquisitions, borrowings, dividends,
locations of branch offices and capital requirements.
The OCC's statement of policy on risk-based capital requires that banks maintain
a ratio of qualifying total capital to risk-weighted assets of not less than 8%
(at least 4% of which should be in the form of Tier 1 Capital). The regulations
set forth minimum requirements, and the OCC has reserved the right to require
that banks maintain higher capital ratios. Among other rights, the OCC's
regulations provide that capital requirements may be enforced by the issuance of
a directive. At December 31, 1995, the Bank had a ratio of Tier 1 capital to
risk-weighted assets of 6.95%. The Tier 1 capital to risk weighted assets ratio
of 6.95% was less than the 10% required by the Formal Agreement. The OCC's
capital adequacy regulations require that banks maintain a minimum leverage
standard of 4% Tier 1 Capital to total assets. As of December 31, 1995, the
Bank's leverage ratio was 4.67%, which is less then 6.50% required by the Formal
Agreement. A Capital Plan was filed with the OCC on February 8, 1996. For a more
complete description of the OCC's risk-based capital regulations, see "Item 1.
BUSINESS -- Effect of Governmental Policies and Recent Legislation -- Capital
Adequacy Guidelines" and see "Item 1. BUSINESS -- Effect of Governmental
Policies and Recent Legislation -- Federal Deposit Insurance Corporation
Improvement Act of 1991 -- Prompt Corrective Action."
Restrictions on Transfers of Funds to the Company by the Bank
Federal Reserve Board policy prohibits a bank holding company from declaring or
paying a cash dividend which would impose pressure on the capital of subsidiary
banks or would be funded only through borrowings or other arrangements that
might adversely affect the holding company's financial position. The policy
further declares that a bank holding company should not continue its existing
rate of cash dividends on its common stock unless its net income is sufficient
to fully fund each dividend and its prospective rate of earnings retention
appears consistent with its capital needs, asset quality and overall financial
condition. Other Federal Reserve Board policies forbid the payment by bank
subsidiaries to their parent companies of management fees which are unreasonable
in amount or exceed the fair market value of the services rendered (or, if no
market exists, actual cost plus a reasonable profit).
The Company is a legal entity separate and distinct from the Bank. At present,
substantially all of the Company's revenues, including funds available for the
payments of dividends and other operating expenses, is, and will continue to be,
primarily dividends paid by the Bank.
There are statutory and regulatory limitations on the amount of dividends which
may be paid to the Company by the Bank. The prior approval of the OCC is
required if the total of all dividends declared by a national bank in any
calendar year exceeds the bank's net profits (as defined) for that year combined
with its retained net profits (as defined) for the preceding two years, less any
transfers to surplus. At December 31, 1995, the Bank did not have funds
available for the payment of cash dividends. In addition, under the Amended
Formal Agreement, the Bank is prohibited from paying cash dividends without the
prior approval of the OCC. See "Item 7. Management's Discussion and
Analysis -- Regulatory Agreements."
Under the prompt corrective action rules of FDICIA, no depository institution,
such as the Bank, may issue a dividend or pay a management fee if it would cause
the institution to become undercapitalized. Additionally, a bank holding company
controlling a significantly undercapitalized institution may not make any
capital distributions without the prior approval of the Federal Reserve Board.
Other supervisory actions may be taken against institutions that are
significantly undercapitalized, as well as
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undercapitalized institutions that fail to submit an acceptable capital
restoration plan as required by law or that fail in any material respect to
implement an accepted plan.
The OCC has authority to prohibit the Bank from engaging in activities that, in
the OCC's opinion, constitute unsafe or unsound practices in conducting its
business. It is possible, depending upon the financial condition of the Bank and
other factors, that the OCC could assert that the payment of dividends or other
payments might, under some circumstances, be such an unsafe or unsound practice.
Further, the OCC and the Federal Reserve Board have established guidelines with
respect to the maintenance of appropriate levels of capital by banks or bank
holding companies under their jurisdiction. Compliance with the standards set
forth in such guidelines and the restrictions that are or may be imposed under
the prompt corrective action provisions of federal law could limit the amount of
dividends which the Bank or the Company may pay. See "Item 1. BUSINESS -- Effect
of Governmental Policies and Recent Legislation -- Federal Deposit Insurance
Corporation Improvement Act of 1991" for a discussion of additional restrictions
on capital distributions.
The Bank is subject to certain restrictions imposed by federal law on any
extensions of credit to, or the issuance of a guarantee or letter of credit on
behalf of, the Company or other affiliates, the purchase of or investment in
stock or other securities thereof, the taking of such securities as collateral
for loans and the purchase of assets of the Company or other affiliates. Such
restrictions prevent the Company and such other affiliates from borrowing from
the Bank unless the loans are secured by marketable obligations of designated
amounts. Further, such secured loans and investments by the Bank to or in the
Company or to or in any other affiliate is limited to 10% of the Bank's capital
and surplus (as defined by federal regulations) and such secured loans and
investments are limited, in the aggregate, to 20% of the Bank's capital and
surplus (as defined by federal regulations). Additional restrictions on
transactions with affiliates may be imposed on the Bank under the prompt
corrective action provisions of federal law.
Compliance with Environmental Regulation
Management of the Company and its subsidiaries is unaware of any material effect
upon the Company's and the Company's subsidiaries' capital expenditures,
earnings or competitive position as a result of compliance with federal, state
and local provisions which have been enacted or adopted regulating the discharge
of materials into the environment or otherwise relating to the protection of the
environment. Based on current federal, state and local environmental laws and
regulations, the Company does not intend to make any material capital
expenditures for environmental control facilities for either the remainder of
its current fiscal year or its succeeding fiscal year.
Community Reinvestment Act
The Community Reinvestment Act (CRA) requires each bank, as well as other
lenders, to identify the communities served by the institution's offices,
including low- and moderate-income neighborhoods, and to identify the types of
credit the institution is prepared to extend within such communities. The CRA
also requires the OCC to assess the performance of the bank in meeting the
credit needs of its community and to take such assessment into consideration in
reviewing applications for mergers, acquisitions and other transactions. An
unsatisfactory CRA rating may be the basis for denying such an application.
In connection with its assessment of CRA performance, the OCC assigns a rating
of "outstanding", "satisfactory", "needs to improve", or "substantial
noncompliance". Based on an examination conducted during 1993, the Bank was
rated satisfactory.
Employees
As of March 25, 1996, the Company had no employees and the Bank had 53 full-time
equivalent employees. The Company and the Bank believe that the Bank's employee
relations are satisfactory.
ITEM 2. PROPERTIES
The Bank leases space in an office building at 1840 Century Park East, Los
Angeles, California. As of December 31, 1995, the Bank entered into a Lease
Restructure Agreement with its landlord, which modified the Bank's future lease
obligations by substantially reducing its rent expense. As a result of the
modifications to the leases (the "Lease Modification"), the Bank reduced its
space under its leases from approximately 42,400 square feet to 23,883 square
feet. Further, the Lease Modification resulted in a decrease in the effective
rent per square foot from approximately $4.00 to $2.33 or $55,666 per month for
the period November 1, 1995 to October 31, 2000. Such reduction approximates
$4.3 million during the first five years under the
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Lease Modification. The effective rent for the period November 1, 2000 to
October 31, 2004 will be $2.83 per square foot or $67,607 per month and 1996 the
base year for annual adjustments for increases in property taxes and operating
costs.
Under the provision of the Lease Restructure Agreement, the Bank assigned its
interests in its subleases to the landlord and, the Company issued the landlord
a seven year warrant to purchase up to 9.9% of the shares of common stock of the
Company at an exercise price of $1.50 per share (or such lower price as provided
in the Warrant Agreement). The Company also granted the landlord registration
rights with respect to shares purchased by the landlord (or its assignee)
pursuant to the Warrant.
The Company does not directly own or lease any property. Its administrative
offices are located at the Bank's headquarters at 1840 Century Park East, Los
Angeles, California 90067.
ITEM 3. LEGAL PROCEEDINGS
Due to the nature of their business, the Company and the Bank are parties to
claims and legal proceedings arising in the ordinary course of business. After
taking into consideration information furnished by counsel to the Company and
the Bank as to the current status of various claims and proceedings to which any
of the Company or the Bank is a party, management of the Company is of the
opinion that the aggregate potential liability represented thereby will not have
a material adverse effect upon the consolidated financial condition of the
Company.
On or about October 7, 1992, an action was commenced by two shareholders,
Messrs. Berlin and Zlotnick, of National Mercantile Bancorp, in the United
States District Court for the Eastern District of Pennsylvania against the
Company and the following former and current directors, officers, and/or
employees of the Company: Messrs. Ladd, Thornburg, Hughes, Tomich, Bell,
Guldeman, Smith, Brewer, Wolfen, Winner, Thomson, Hickey, Grahm, and Domyan and
Ms. Romero and Ms. Thornton. The plaintiffs contended that the claims were being
asserted (a) on a derivative basis on behalf of the Company and (b) on behalf of
a purported class of (i) purchasers of the Company's stock during the period
October 7, 1989 through July 12, 1994 and (ii) persons who owned shares of the
Company on the record dates and who were eligible to vote at the 1990, 1991 and
1992 Annual Meetings of Shareholders of the Company. In or about November 1993,
the action was transferred, on consent of all parties, to the United States
District Court of California (the "Court").
The complaint purported to assert various violations of the Exchange Act and
state common law claims for violation of the directors' alleged duty of candor,
common law negligent misrepresentation and breach of fiduciary duty, and waste
of corporate assets. The plaintiffs sought class certification, declaratory and
injunctive relief, consequential and punitive damages in an unspecified amount
and attorneys' fees.
On December 22, 1994, the parties to the action filed a stipulation of
settlement (the "Stipulation") with the Court. According to the Stipulation, all
claims in the action were to be settled, discharged and dismissed with
prejudice. The monetary portion of the settlement was to be funded solely by the
Company's insurer for the relevant time period (approximately $1.6 million was
being held in an escrow account) and none of the defendants were to be required
to pay any portion of the settlement. The stipulation was approved by the Court
on May 1, 1995 and the period for appeal has expired. This action has been
concluded except for the issuance of warrants and the election of the two new
directors as stipulated. The Company will be required to issue warrants to the
class to purchase shares of the common stock of the Company equal to 5.0% of the
fully diluted issued and outstanding shares of the common stock of the Company
as of July 12, 1994. The exercise price of the warrants shall be $3.55 per
warrant. The warrants shall be exercisable during a three year period commencing
June 2, 1996 and ending June 2, 1999. Pursuant to the Court's order, plaintiffs'
attorneys received 30% of the monetary portion of both the derivative and class
settlement amount and will receive 30% of the warrants. Also, pursuant to the
Court's order, in the two year period after the approval of the proposed
settlement, the Company will be required to recommend the election of two new
members to its board of directors from a list supplied by the plaintiffs.
In February 1995, counterclaims were filed against the Bank in an action
commenced by British & Commonwealth Merchant Bank ("BCMB"), as agent for itself
and the Bank, in England against Lloyd's Underwriters and Company Underwriters
(collectively, "Lloyd's"). The Bank and BCMB claim that Lloyds owes them a
further $120,659 of insurance proceeds relating to a claim filed by BCMB (for
itself and the Bank) for approximately $7.8 million under policies insuring
repayment of a loan from the Bank and BCMB to Performance Guarantees, Inc. for
production of a film entitled "Barr Sinister". In or about November 1991,
Lloyd's paid approximately $7.8 million in insurance proceeds, which Lloyd's now
seeks to recover a half each from the Bank and BCMB. In its counterclaim,
Lloyd's contends that the Leading Underwriter lacked authority to issue the
insurance policies and endorsements on behalf of all of the insurers under which
payment was made and secondly, that material
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misrepresentations were made to the Leading Underwriter as to the likely budget
for the film and that if the Leading Underwriter had known the true position he
would not have accepted the film under the relevant policies. Lloyd's position,
therefore, is that such payment should be returned to Lloyd's.
The Bank believes it has meritorious defenses to these counterclaims and intends
to defend the counterclaims vigorously. The Bank also believes that, if it is
unsuccessful in the counterclaims, the Bank has claims against other parties for
recovery of any amounts it may have to repay to Lloyd's.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of shareholders during the fourth quarter of
1995.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The common stock of the Company is traded in the over-the-counter market on the
National Association of Securities Dealers' National Market System, under the
symbol MBLA. The following table shows the high and low closing prices of the
Company's common stock for each quarter of 1994 and 1995 as quoted by the
National Association of Securities Dealers Automated Quotation System
("NASDAQ"). Additionally, there may have been transactions at prices other than
those shown during that time.
HIGH LOW
----- -----
Quarter Ended:
March 31, 1994 $5.25 $4.00
June 30, 1994 4.50 3.50
September 30, 1994 5.25 4.00
December 31, 1994 4.88 2.63
March 31, 1995 3.75 2.06
June 30, 1995 4.00 3.50
September 30, 1995 4.00 2.75
December 31, 1995 3.50 1.25
At March 25, 1996, the closing sales price for the Company's common stock as
quoted by NASDAQ was $2.06 per share. At March 25, 1996, the Company had 285
shareholders of record.
"Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS -- Capital Resources" and "Regulatory Agreements", and Note 14 of
the notes to consolidated financial statements in "Item 8. FINANCIAL STATEMENTS"
describe the statutory and regulatory limitations on the payment of cash
dividends by national banks. As a result of those limitations and reported net
losses, at December 31, 1995, the Bank could not declare dividends to the
Company without the prior approval of the OCC. In addition, the Formal Agreement
with the OCC substantially impairs the ability of the Bank to pay dividends to
the Company during the foreseeable future. As dividends from the Bank are the
primary source of income to the Company, it is unlikely that the Company will
declare and pay dividends in the foreseeable future. Further, pursuant to the
Memorandum of Understanding with the FRBSF, the Company has agreed to refrain
from paying dividends without the prior written approval of the FRBSF. The
Company does not intend to request approval to pay any dividends during 1996.
The Company did not pay dividends in 1995, 1994 or 1993.
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ITEM 6. SELECTED FINANCIAL DATA
As of and for the years ended December 31,
--------------------------------------------------------------
1995 1994 1993 1992 1991
---------- ---------- ---------- ---------- ----------
(dollar amounts in thousands, except per share data)
CONSOLIDATED BALANCE SHEET:
Total cash and cash equivalents $ 30,272 $ 46,710 $ 53,355 $ 67,879 $ 103,948
Total trading securities -- -- 9,992 6,069 3,564
Total debt securities available-for-sale 20,417 62,056 62,022 -- 27,868
Total investment securities held-to-maturity and
interest bearing deposits with other financial
institutions -- 195 11,759 97,145 24,234
Loans held for sale -- 6,599 -- -- --
Total gross loans 82,012 115,284 161,791 175,736 231,324
Allowance for credit losses (3,805) (3,063) (6,697) (6,009) (8,381)
Total earning assets 119,624 205,571 276,367 315,941 341,782
Total assets 131,992 232,979 303,120 351,638 394,971
Total deposits 120,243 207,815 268,846 308,236 324,137
Total shareholders' equity $ 6,011 $ 10,308 $ 22,199 $ 21,601 $ 24,569
Regulatory risk-based capital (1):
Minimum required risk-based capital $ 7,085 $ 10,862 $ 14,606 $ 17,548 19,397
Excess risk-based capital $ 221 $ 4,217 $ 9,582 $ 6,835 9,251
Risk-based capital ratio 8.25% 11.11% 13.25% 11.12% 10.71%
Minimum required risk-based capital ratio (2) 8.00% 8.00% 8.00% 8.00% 7.25%
Regulatory capital leverage ratio (2) 4.68% 5.65% 7.11% 7.39% 7.91%
Average shareholders' equity to average total
assets 6.05% 7.77% 7.46% 8.37% 7.57%
Fully diluted book value per common share $ 1.95 $ 3.34 $ 6.90 $ 7.12 $ 8.09
Allowance for loan losses as percent of period-end
gross loans outstanding 4.64% 2.66% 4.14% 3.42% 3.62%
Allowance for loan losses as percent of
nonperforming loans 63.83% 29.13% 42.21% 52.68% 45.21%
Allowance for loan losses as percent of unsecured
nonperforming loans 1135.82% 118.86% 106.51% 726.60% 199.69%
Average loans to average total deposits 70.54% 65.84% 63.38% 78.15% 86.30%
CONSOLIDATED OPERATING RESULTS:
Net interest income $ 7,655 $ 15,374 $ 14,692 $ 14,956 $ 19,826
Other (losses) income (1,315) (2,857) 1,474 2,140 3,167
Provision for loan losses 2,307 7,330 2,000 3,050 9,680
(Loss) income before cumulative effect of change
in accounting principle $ (7,200) $ (8,527) $ 108 $ (2,968) $ (3,907)
Net (loss) income $ (7,200) $ (8,527) $ 171 $ (2,968) $ (3,907)
(Loss) income per share before cumulative effect
of change in accounting principle $ (2.34) $ (2.79) $ 0.03 $ (0.98) $ (1.29)
Fully diluted (loss) income per share $ (2.34) $ (2.79) $ 0.05 $ (0.98) $ (1.29)
Fully diluted weighted average common and
equivalents shares outstanding 3,078,146 3,055,584 3,171,250 3,035,660 3,037,700
Interest rate spread 3.77% 5.43% 4.44% 4.23% 3.84%
Net yield on earning assets 5.52% 6.77% 5.56% 5.53% 5.85%
(Loss) return on average total assets (4.82)% (3.47)% 0.06% (1.01)% (1.04)%
(Loss) return on average total shareholders'
equity (79.70)% (44.68)% 0.79% (12.04)% (13.69)%
Cash dividends per common share $ N/A $ N/A $ N/A $ N/A $ N/A
Dividend payout ratio N/A N/A N/A N/A N/A
- ---------------
(1) In December 1988, the Board of Governors of the Federal Reserve System
("FRB") adopted risk-based capital guidelines for bank holding companies.
Those guidelines became effective on December 31, 1990, to be implemented
over a transition period that ended on December 31, 1992. Risk-based capital
information as of December 31, 1991 is computed under these transitional
rules. Risk-based capital information as of December 31, 1995, 1994, 1993
and 1992 is computed under fully phased-in rules.
(2) The Company's only subsidiary, Mercantile National Bank, must maintain
capital in accordance with the Bank's existing regulatory agreement. At
December 31, 1995, the Bank did not meet either the 6.50% required capital
leverage ratio or the 10% Tier 1 capital to risk weighted assets ratio. See
Note 2 of the Notes to Consolidated Financial Statements.
For further discussion of regulatory capital requirements applicable to the
Company and the Bank, (see "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations -- Capital Resources" and
"Regulatory Agreements").
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This section presents management's discussion and analysis of the consolidated
financial condition and operating results of National Mercantile Bancorp (the
"Company") and its subsidiary, Mercantile National Bank (the "Bank"), for the
years ended December 31, 1995, 1994 and 1993. The discussion should be read in
conjunction with the Company's consolidated financial statements and
accompanying notes to the consolidated financial statements. (See "Item 8.
FINANCIAL STATEMENTS.") Averages presented in the tables are daily average
balances unless otherwise stated. See "Cautionary Statement for Purposes of the
'Safe Harbor' Provisions of the Private Securities Litigation Reform Act of
1995."
SUMMARY OF PERFORMANCE
The Company's net loss for the year ended December 31, 1995, was $7.2 million or
$2.34 per share as compared to a net loss of $8.5 million or $2.79 per share for
the year ended December 31, 1994. Declining loan balances continued to
negatively impact the Company's loan interest income, while sales of securities
resulted in decreased interest income from securities in 1995. Sales of
investment securities available for sale made as a part of the Company's planned
restructuring of the securities portfolio resulted in realized losses of $2.5
million in 1995. The net loss for the year ended December 31, 1994 included a
loss of $1.1 million on other assets discussed below. Other operating expenses
decreased 18.1% for the year ended December 31, 1995, as compared to the year
ended December 31, 1994. The decrease was due primarily to management's efforts
to continue to reduce operating expenses. Compensation expense decreased $1.4
million or 25.9% for the year ended December 31, 1995, as compared to the year
ended December 31, 1994. The Company's net loss for the year ended December 31,
1994, was $8.5 million or $2.79 per share as compared to net income of $171,000
or $.05 per share for the year ended December 31, 1993. The 1994 net loss was
primarily attributed to the $5.3 million increase in the provision for credit
losses to $7.3 million from $2.0 million in 1993; the realized losses of $1.3
million from the sale of investment securities available-for-sale, which is part
of the Company's planned restructuring of the securities portfolio to minimize
future interest rate risk; loss on other assets of $1.1 million, representing a
film library which was used as collateral for a loan; and the lower of cost or
market adjustment of $851,000 on loans that were held for sale at December 31,
1994, which is also part of the Company's plan to reduce classified and
nonperforming loans.
Net interest income for the year ended December 31, 1995 was $7.7 million
compared to $15.4 million for the year ended December 31, 1994. Decrease in net
interest income was due to the decrease in interest earning loans and
securities. Net interest income for the year ended December 31, 1994, was $15.4
million compared to $14.7 million for 1993. The 4.64% net increase was
attributed to the accretion of discount on loans purchased in 1993 and offset by
lower net interest income due to lower average balances of net earning assets
during 1994 compared to 1993. (See "Net interest Income and Interest Rate
Risk.") In September 1993, the Company acquired through its wholly owned
subsidiary, the Bank, $20.8 million of loans from the FDIC acting as receiver
for a bank in Los Angeles. The purchase price was $16.8 million, net of an
allowance for credit losses established by the Bank at the time of purchase.
Subsequent to 1993 the allowance for credit losses established at the time of
purchase was reclassified as a purchase discount on loans. The total net
discount of $4.0 million is being accreted into interest income over the term of
the related loans.
The allowance for credit losses increased to $3.8 million at December 31, 1995,
compared to $3.1 million at December 31, 1994 although the provision for credit
losses was $2.3 million for the year ended December 31, 1995, compared to $7.3
million for the year ended December 31, 1994. The Bank's allowance for credit
losses as a percentage of nonperforming loans increased to 63.8% at December 31,
1995 from 29.1% at December 31, 1994, as a result of the 43.3% decrease in
nonperforming loans during the year ended December 31, 1995 and the increased
provision for loan losses. In February 1995, to improve asset quality and future
profitability, the bank sold criticized and/or nonperforming loans and loans
that were previously charged off, in the amount of $6.6 million which
represented 16.6% of the decrease in loans. The 1994 provision for credit losses
of $7.3 million, increased 267% from $2.0 million for 1993. A higher provision
for credit losses was necessary as loan losses for the year increased, net
charge-offs increased to $11.0 million for 1994 from $1.3 million for 1993.
Included in the net charge-offs for 1994 was $4.0 million of charged-off loans
from the 1993 purchased loan portfolio and $2.0 million of charged-off loans
related to the loans held-for-sale at December 31, 1994.(See "Credit Portfolio
Composition and Credit Risk")
Total assets of the Company at December 31, 1995, were $132.0 million, a
decrease of $101.0 million or 43.3% from total assets at December 31, 1994 of
$233.0 million. The decrease was due to a $41.6 million decrease in securities,
a $34.0 million
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decrease in net loans, the sale of loans discussed above, and a $16.4 million
decrease in cash and cash equivalents. At the same time, customer deposits
decreased by $87.6 million or 42.1% to $120.2 million at December 31, 1995, from
$207.8 million at December 31, 1994. Securities sold under agreements to
repurchase decreased by $8.1 million or 64.2% to $4.5 million at December 31,
1995, from $12.6 million at December 31, 1994. Total assets of the Company at
December 1994, were $233.0 million compared to $303.1 million at December 31,
1993. As a part of the Company's capital plan for the Bank and its restructuring
of the organization to return to profitability, the Company reduced the Bank's
asset size through sales of securities available-for-sale which were funded by
high cost deposits, reduced classified assets through the sales of loans and
OREO, and reduced operating expenses through consolidating functions and
reduction of personnel. The restructuring of the Bank began during the third
quarter of 1994 and the Bank continues to improve the quality of its assets,
minimize its interest rate risk, generate fee income and reduce overhead
expenses in efforts to return to profitability. However, should a reduction in
asset size continue to occur without corresponding reductions in operating
expenses, interest income from the reduced earning asset base may not cover
operating expenses.
LOAN SALES
To improve asset quality and future profitability, the Bank sold in February,
1995, loans amounting to $6.6 million, net, which consisted of criticized and/or
nonperforming loans and loans that were previously charged-off. During the
fourth quarter of 1994, the Bank sold charged-off loans and recovered $750,000
which was recorded as loan recoveries in the allowance for credit losses.
At December 31, 1994, the loans sold in February 1995 were carried based on the
sales price net of the lower of cost of market adjustment of $851,000. They
represented nonperforming loans and other criticized loans with outstanding
principal balances of $7.5 million, net of charge-offs totaling $2.0 million,
and loans that were previously charged-off totaling approximately $4.0 million.
LOAN PORTFOLIO COMPOSITION AND CREDIT RISK
The gross loan portfolio decreased to $82.0 million at December 31, 1995, from
$115.3 million at December 31, 1994, or by 28.9%. Table 3 indicates that the mix
of portfolio at December 31, 1995, had a larger portion of loans secured by real
estate, representing approximately 65% of total loans as compared to 49% at
December 31, 1994. Other secured and unsecured commercial loans represent 29% of
portfolio at December 31, 1995, a decline from 37% at December 31, 1994, and
consumer loans to individuals represented 6% at December 31, 1995, a decline
from 14% at December 31, 1994.
Effects of the Prolonged Recession and Declining Real Estate Values
The reduction in nonperforming assets to $6.5 million at December 31, 1995, from
$12.0 million at December 31, 1994, was primarily as a result of improved
collections and the sale of loans and OREO. Net loan charge-offs for 1994 were
at an historic high level totaling $11.0 million as compared to $1.3 million in
1993, and included $4.0 million of charged-off loans related to the loans
purchased in 1993 and $2.0 million of charge-offs related to the loans
held-for-sale at December 31, 1994. Net loan charge-offs for 1995 were $1.6
million. The high level of losses reflect the continued adverse impact of the
southern California recession.
While economic conditions nationally and elsewhere in California are improving,
southern California's economy remained weak. Although the southern California
economy appears to have bottomed out, no assurance can be given that conditions
in southern California will improve in the near future.
Asset Quality
The Bank has implemented an enhanced process by which it reviews and manages the
credit quality of the loan portfolio. An officer loan committee has been
established with the Bank's senior officers serving as voting members. The
ongoing credit control process includes a stringent risk rating system, enhanced
underwriting criteria, early identification of problem credits, regular
monitoring of classified assets graded as "criticized" by the Bank's internal
grading system and an independent loan review process. The loan approval process
is also tied to the risk rating system.
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Asset quality of the Bank improved during 1995; nonperforming assets decreased,
as well as classified loans. Classified loans at December 31, 1995, decreased to
$14.5 million from $18.4 million at December 31, 1994. The loans held-for-sale
at December 31, 1994, which were sold in February 1995, discussed above, further
augmented a reduction in criticized and nonperforming loans.
Nonperforming Assets
Nonperforming assets consist of nonperforming loans and other real estate owned.
Nonperforming loans are those loans which have (i) been placed on nonaccrual
status, (ii) been subject to troubled debt restructurings, or (iii) become
contractually past due ninety days with respect to principal or interest and
have not been restructured or placed on nonaccrual status, as described below.
Other real estate owned consists of real properties securing loans on which the
Bank has taken title in partial or complete satisfaction of the loan.
Information about nonperforming assets is presented in Table 1.
1995 Compared to 1994. At December 31, 1995, nonperforming assets totalled $6.5
million or 8.0% of total loans outstanding. This represents a decrease of $5.5
million or 45.7% from December 31, 1994. The decrease in nonperforming assets
was due primarily to improved collection procedures, the sales of loans and OREO
in 1995. One loan, classified as a Troubled Debt Restructuring at December 31,
1995, represented $4.9 million of the total of $6.5 million and is secured by a
First Trust Deed on property with a current appraisal value of $10.0 million.
1994 Compared to 1993. At December 31, 1994, nonperforming assets totaled $12.0
million or 9.9% of total loans outstanding. This represents a decrease of $10.0
million or 45.5% from 1993. Included in nonperforming assets were $4.3 million
of loans that were held-for-sale at December 31, 1994, and sold in February
1995.
Nonaccrual Loans
Nonaccrual loans are those for which management has discontinued accrual of
interest because there exists reasonable doubt as to the full and timely
collection of either principal or interest.
When a loan is placed on nonaccrual status, all interest previously accrued but
uncollected is reversed against current period operating results. Income on such
loans is then recognized only to the extent that cash is received and where the
ultimate collection of the carrying amount of the loan is probable, after giving
consideration to the borrower's current financial condition, historical
repayment performance and other factors. Accrual of interest is resumed only
when (i) principal and interest are brought fully current and (ii) such loans
are either considered, in management's judgment, to be fully collectible or
otherwise become well secured and in the process of collection. (See "Net
Interest Income and Interest Rate Risk" for a discussion of the effects on
operating results of nonperforming loans.)
Nonaccrual loans at December 31, 1995, decreased significantly to $573,000 from
$3.4 million at December 31, 1994 and $7.8 million at December 31, 1993.
Troubled Debt Restructurings
Included within nonperforming assets are troubled debt restructurings ("TDR").
TDR is defined in Statement of Financial Accounting Standards No. 15 and No. 114
(see discussion below) as a loan for which the Company has, for economic or
legal reasons related to a borrower's financial difficulties, granted a
concession to the borrower it would not otherwise consider, including
modifications of loan terms to alleviate the burden of the borrower's near-term
cash flow requirements in order to help the borrower to improve its financial
condition and eventual ability to repay the loan. Loans for which the Company
had modified the terms of loans to borrowers by reductions in interest rates at
below-market rates for loans with similar credit risk characteristics or
extensions of maturity dates are presented in Table 1.
Recent Accounting Developments
In October 1994 the Financial Accounting Standards Board ("FASB") issued
Statement of Accounting Standards ("SFAS") SFAS No. 118, "Accounting by
Creditors for Impairment of a Loan -- Income Recognition and Disclosures", that
amends SFAS No. 114 "Accounting by Creditors for Impairment of a Loan" and
eliminates its provisions regarding how a creditor should report income on an
impaired loan and clarifies certain disclosure requirements. SFAS No. 114,
issued by FASB in May 1993, prescribes the recognition criterion for loan
impairment and the measurement methods for certain impaired loans and loans
whose terms are modified in troubled debt restructurings. SFAS No. 114 states
that a loan is impaired when it is
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probable that a creditor will be unable to collect all principal and interest
amounts due according to the contracted terms of the loan agreement. A creditor
is required to measure impairment by discounting expected future cash flows at
the loan's effective interest rate, by reference to an observable market price,
or by determining the fair value of the collateral for a collateral dependent
asset when the creditor determines foreclosure is probable. The Statement also
clarified the existing accounting for in-substance foreclosures ("ISFs") by
stating that a collateral dependent real estate loan would be reported as real
estate owned only if the lender had taken possession of the collateral. Both
Statements are effective for financial statements issued for fiscal years
beginning after December 15, 1994.
SFAS No. 118 and No. 114 were adopted by the Bank in the first quarter of 1995,
and did not have a material effect on the financial condition or results of
operations of the Bank.
Loans Contractually Past Due Ninety or More Days
Loans contractually past due ninety or more days are those loans which have
become contractually past due ninety days with respect to principal or interest.
Interest accruals may be continued for loans that have become contractually past
due ninety days when such loans are well secured and in the process of
collection and, accordingly, management has determined such loans to be fully
collectible as to both principal and interest.
For this purpose, loans are considered well secured if they are collateralized
by property having a realizable value in excess of the amount of principal and
accrued interest outstanding or are guaranteed by a financially capable party.
Loans are considered to be in the process of collection if collection of the
loan is proceeding in due course either through legal action or through other
collection efforts which management reasonably expects to result in repayment of
the loan or its restoration to a current status in the near future.
Loans contractually past due ninety or more days decreased to $221,000 at
December 31, 1995, from $1.5 million at December 31, 1994, and $2.5 million at
December 31, 1993.
Other Real Estate Owned ("OREO")
The Bank reduced OREO to $581,000, which represents two properties, at December
31, 1995, from $1.5 million at December 31, 1994 and $6.2 million at December
31, 1993 through sales and the establishment of valuation reserves. Net losses
on OREO were $733,000 in 1995.
Management periodically (no less often than annually) reappraises the value of
the Bank's foreclosed properties or uses the current offer prices in order to
establish current estimated fair values. If the estimated fair value is lower
than the property's carrying value, a direct charge is taken against earnings.
Potential Nonperforming Loans
At December 31, 1995, management identified potential nonperforming loans as
presented in Table 2. Potential nonperforming loans are those which are not
already disclosed as nonperforming, as defined above, but where known
information about possible credit problems causes management to have doubts as
to the ability of such borrowers to comply with the present loan repayment terms
and which may result in the designation of such loans as nonperforming.
Management is unable to predict the extent to which potential nonperforming
loans may ultimately be designated nonperforming, since, as discussed below,
those events are largely dependent on future conditions outside the Company's
control. Further deterioration of residential and commercial real estate values
may continue to affect adversely the Company's level of nonperforming loans and
provisions for credit losses. At December 31, 1995, potential nonperforming
loans increased to $1.6 million from $773,000 at December 31, 1994.
Loan Delinquencies
Total loan delinquencies decreased to $1.2 million, or 1.6% of net loans
outstanding at December 31, 1995, from $6.4 million or, 5.1% of net loans
outstanding at December 31, 1994.
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Allowance for Loan Losses
The Bank has a process by which it reviews and manages the credit quality of the
loan portfolio. The ongoing credit control process includes a stringent risk
rating system, enhanced underwriting criteria, early identification of problem
credits, regular monitoring of any classified assets graded as "criticized" by
the Bank's internal grading system and an independent loan review process. The
loan approval process is also tied to the risk rating system. The Classified
Asset Committee ("CAC") meets on a monthly basis to review, monitor and take
corrective action upon all criticized assets and review the adequacy of the
allowance for loan losses. This Committee is chaired by the Chief Credit Officer
with the results of the CAC's meetings reviewed by the officers and Directors'
Loan Committees monthly.
In evaluating the adequacy of the allowance for loan losses, management
estimates the amount of potential risk of loss for each loan that has been
identified as having a higher credit risk (including, among other loans, all
loans identified as nonperforming or potential nonperforming). Those estimates
give consideration to economic conditions and their effect on the borrower's
industry; the borrower's financial data and management capabilities; and current
valuations of collateral where appropriate. A general allowance for loan losses
is determined for all loans based upon the risk characteristics of particular
categories of loans and historical loss experience. Additional allowances are
allocated based on concentrations in the portfolio, commitments and contingent
obligations. The general allowance recognizes potential losses in both
commercial and standby letters of credit.
Management believes that the allowance for loan losses at December 31, 1995, was
adequate to absorb estimated losses in the existing portfolio, including
commitments under commercial and standby letters of credit. However, no
assurance can be given on how continued weaknesses in the real estate market or
future changes in economic conditions might affect the Bank's principal market
area and may result in increased losses in the Bank's loan portfolio.
Table 3 presents, for the five-year period ended December 31, 1995, the
composition of the Company's loan portfolio and allocation of the allowance for
loan losses to specific loan categories designated by management for this
purpose. This allocation should not be interpreted as an indication that loan
charge-offs will occur in these amounts or proportions, or as an indication of
future charge-off trends. In addition, the portion of the allowance allocated to
each loan category does not represent the total amount available for future
losses that may occur within such categories, since the total allowance is
applicable to the entire portfolio.
Provision for Loan Losses
The provision for loan losses for 1995 was $2.3 million as compared to $7.3
million for 1994. The 1994 provision was attributed to the $20.8 million loan
portfolio purchased in 1993. At the time of purchase in 1993 the Bank had
recorded an allowance for loan losses of $4.0 million. This allowance was
subsequently reclassified as a purchase discount and accreted over the term of
the related loans. Concurrent with this reclassification in 1994, the Bank added
$4.1 million to the provision for loan losses to absorb loss from this
portfolio. Charge-offs related to the $20.8 million of purchased loans totaled
$4.0 million during 1994. The decrease in the provision for 1995 resulted from
the decrease in loan balances, the sale of loans, improved collections and
reduced net charge-offs in 1995.
Loan Charge-Offs
Management regularly monitors the loan portfolio to identify promptly loans that
may become nonperforming and conducts an on-going evaluation of the Company's
exposure to potential loss arising from such loans, as discussed above. Loan
losses are fully or partially charged against the allowance for loan losses
when, in management's judgment, the full collectibility of a loan's principal is
in doubt. However, there is no precise method of predicting specific losses
which ultimately may be charged against the allowance in future periods.
1995 Loan Charge-Offs. Loan charge-offs during 1995 were $2.6 million as
compared to the $14.2 million during 1994. The decrease resulted from the
decrease in loan balances, the sale of loans, improved collections and reduced
net charge-offs in 1995.
1994 Loan Charge-Offs. During 1994 loan charge-offs were at an historic high
level totaling $14.2 million compared to $2.4 million for 1993. The high level
of charge-offs was attributed to the losses in the $20.8 million purchased loan
portfolio of $4.0 million, the charge-off of $2.0 million related to the loan
sale of criticized and/or nonperforming loans that were held-for-sale at
December 31, 1994, and sold in February 1995, and a result of the high level of
nonperforming loans from the prior year that the Bank was unable to collect or
ultimately work-out because of the economic factors that negatively impacted
those borrowers.
22
25
Industry Concentrations of Loans and Other Risk Elements
Real Estate-Related and Entertainment Industry Lending. In addition to the
Company's concentration in loans secured by real estate, the Company is a
provider of banking services to the entertainment industry in southern
California. Table 5 presents information about the Company's loans outstanding
to entertainment-related customers at December 31, 1995 and 1994. The
concentration of loans to the entertainment related industry at December 31,
1995, decreased to $5.8 million or 7.1% of the total portfolio as compared to
$21.2 million or 18.4% at December 31, 1994. The amounts presented in Table 5
also include loans to customers in this industry group which are secured by real
estate which represent 12.8% of the total entertainment industry loans at
December 31, 1995, compared to 6.1% at December 31, 1994.
Management believes that the varying nature of customers represented within this
group, as set forth in Table 5, indicates reasonable diversification. In
addition, loans for the production of independently produced motion picture and
television feature films presented in Table 5 are supported, during production,
by performance bonds from highly rated insurers and either distribution
commitments from major studios or, in the case of smaller studios, standby
letters of credit from large commercial banks. Management therefore believes
that this concentration does not represent an undue concentration of credit
risk.
There were no nonperforming loans included in this industry group at December
31, 1994, as compared to $3.1 million at December 31, 1993, or 5.6% of all loans
to this industry group at that time. In addition, loans related to this industry
group which were charged off during the years ended December 31, 1994 and 1993
amounted to $2.0 million (or 9.5% of all such loans) and $545,000 (or 1.0% of
all such loans), respectively.
Table 1
Nonperforming Assets at December 31
1995 1994 1993 1992 1991
------ ------- ------- ------- -------
(dollar amounts in thousands)
Nonaccrual loans $ 573 $ 3,426 $ 7,780 $ 6,316 $15,772
Troubled debt restructurings 5,167 5,582 5,584 5,043 2,199
Loans contractually past due ninety or more
days with respect to either principal or
interest and continuing to accrue interest 221 1,507 2,502 47 568
------ ------- ------- ------- -------
Nonperforming loans 5,961 10,515 15,866 11,406 18,539
Other real estate owned 581 1,529 6,175 5,613 --
------ ------- ------- ------- -------
Total nonperforming assets $6,542 $12,044 $22,041 $17,019 $18,539
====== ======= ======= ======= =======
Allowance for loan losses as a percent of
nonaccrual loans 664.0% 89.4% 86.1% 95.1% 53.1%
====== ======= ======= ======= =======
Allowance for loan losses as a percent of
nonperforming loans 63.8% 29.1% 42.2% 52.7% 45.2%
====== ======= ======= ======= =======
Total nonperforming assets as a percent of
gross loans outstanding 8.0% 10.4% 13.6% 9.7% 8.0%
====== ======= ======= ======= =======
Total nonperforming assets as a percent of
total shareholders' equity 108.8% 116.8% 99.3% 78.8% 75.5%
====== ======= ======= ======= =======
Table 2
Potential nonperforming loans at December 31, 1995
Amount Percent
------ -------
(dollar amounts in
thousands)
Commercial loans:
Secured by commercial real properties $ 129 8%
Other -- secured and unsecured 1,212 73%
Home equity lines of credit 47 3%
Consumer instalment and other loans 261 16%
------ ----
$1,649 100%
====== ====
23
26
Table 3
Loan Portfolio Composition and Allocation of the
Allowance for Loan Losses at December 31
1995 1994 1993 1992 1991
------------- -------------- -------------- -------------- --------------
(dollar amounts in thousands)
Loan Portfolio Composition:
Real estate construction and land
development $ 1,093 1% $ 948 1% $ 1,676 1% $ 5,407 3% $ 27,682 12%
Commercial loans:
Secured by one-to-four family residential
properties 11,012 13% 18,398 16% 20,098 12% 27,801 16% 42,524 18%
Secured by multifamily residential
properties 2,538 3% 2,368 2% 4,985 3% 8,651 5% 6,710 3%
Secured by commercial real properties 33,556 41% 32,061 28% 40,330 25% 46,772 27% 43,141 19%
Other -- secured and unsecured 23,327 28% 43,385 37% 67,614 41% 62,973 36% 79,966 34%
Home equity lines of credit 5,857 7% 2,867 2% 7,122 3% 8,030 5% 9,892 4%
Consumer instalment and unsecured loans to
individuals 4,860 7% 15,691 14% 21,124 15% 16,761 8% 23,011 10%
------- --- -------- --- -------- --- -------- --- -------- ---
$82,243 100% $115,718 100% $162,949 100% $176,395 100% $232,926 100%
Deferred net loan origination fees,
purchased loan discount and gains on
termination of interest rate
swap and cap agreements (231) (434) (1,158) (659) (1,602)
------- -------- -------- -------- --------
Gross loans outstanding $82,012 $115,284 $161,791 $175,736 $231,324
======= ======== ======== ======== ========
Allocation of the Allowance for Loan Losses:
Real estate construction and land
development $ 11 $ 17 $ 30 $ 299 $ 1,750
Commercial loans:
Secured by one-to-four family residential
properties 205 77 499 475 432
Secured by multifamily residential
properties 25 51 472 358 37
Secured by commercial real properties 454 674 1,422 1,219 1,272
Other -- secured and unsecured 2,521 1,645 3,130 2,808 3,609
Home equity lines of credit 64 18 149 137 258
Consumer instalment and unsecured loans to
individuals 523 578 988 697 1,018
------- -------- -------- -------- --------
Allowance allocable to gross loans
outstanding 3,803 3,060 6,690 5,993 8,376
Commitments to extend credit under standby
and commercial letters of credit 2 3 7 16 5
------- -------- -------- -------- --------
Total allowance for credit losses $ 3,805 $ 3,063 $ 6,697 $ 6,009 $ 8,381
======= ======== ======== ======== ========
Allowance for credit losses allocable to gross
loans outstanding as a percent of gross
loans outstanding 4.64% 2.66% 4.14% 3.42% 3.62%
======= ======== ======== ======== ========
Average gross loans outstanding during the
year $95,771 $140,079 $159,680 $192,546 $277,669
======= ======== ======== ======== ========
Percent increase (decrease) from previous year
in average gross loans outstanding (31.6)% (12.3)% (17.1)% (30.7)% 2.4%
======= ======== ======== ======== ========
Average gross loans as a percent of average
total earning assets during the year
ended December 31 69.1% 61.7% 60.0% 70.5% 80.7%
======= ======== ======== ======== ========
24
27
Table 4
Analysis of Changes in the Allowance for Loan Losses
1995 1994 1993 1992 1991
------ ------- ------ ------ ------
(dollar amounts in thousands)
Balance at January 1 $3,063 $ 6,697 $6,009 $8,381 $7,124
Loans charged off:
Real estate construction and land development -- 45 558 971 533
Commercial loans:
Secured by one-to-four family residential properties 120 2,215 72 36 964
Secured by multifamily residential properties -- 702 -- 65 300
Secured by commercial real properties -- 1,407 581 519 352
Other -- secured and unsecured 1,913 6,781 774 4,504 6,307
Home equity lines of credit -- 257 -- 153 46
Consumer instalment and unsecured loans to individuals 599 2,810 450 261 811
------ ------- ------ ------ ------
Total loan charge-offs 2,632 14,217 2,435 6,509 9,313
Recoveries of loans previously charged off:
Real estate construction and land development 200 -- 4 2 --
Commercial loans:
Secured by one-to-four family residential properties 11 288 7 9 74
Other -- secured and unsecured 588 2,205 945 1,056 778
Home equity lines of credit -- 38 38 8 --
Consumer instalment and unsecured loans to individuals 268 722 129 12 38
------ ------- ------ ------ ------
Total recoveries of loans previously charged off 1,067 3,253 1,123 1,087 890
------ ------- ------ ------ ------
Net loan charge-offs 1,565 10,964 1,312 5,422 8,423
Provision for loan losses 2,307 7,330 2,000 3,050 9,680
------ ------- ------ ------ ------
Balance at end of period $3,805 $ 3,063 $6,697 $6,009 $8,381
====== ======= ====== ====== ======
Allowance for loan losses as a percent of average annual net loan
charge-offs during the three-year period ended December 31 82.5% 51.9% 132.6% 86.5% 161.3%
====== ======= ====== ====== ======
Provision for loan losses as a percent of net loan charge-offs during
the year ended December 31 147.4% 66.9% 152.4% 56.3% 114.9%
====== ======= ====== ====== ======
Net loan charge-offs as a percent of average gross loans outstanding
during the year ended December 31 1.63% 7.83% 0.82% 2.82% 3.03%
====== ======= ====== ====== ======
Recoveries of loans previously charged off as a percent of loans
charged off in the previous year 7.5% 133.6% 17.3% 11.7% 11.9%
====== ======= ====== ====== ======
Table 5
Industry Concentrations of Loans
1995 1994
------ -------
(dollar amounts in
thousands)
Entertainment industry-related loans at December 31(1):
Loans for single productions of motion picture and television feature films $1,738 $ 5,662
Other loans to entertainment-related enterprises, such as television and
film production or distribution 3,020 4,814
Loans to individuals involved primarily in the entertainment industry 1,663 5,633
Loans to business management, legal and accounting firms, including their
principals and employees, serving primarily the entertainment industry 2,930 5,048
------ -------
Total entertainment industry-related loans(2) $9,352 $21,157
====== =======
Percent of net loans outstanding 11.4% 18.4%
====== =======
- ---------------
(1) Included in Table 5 are loans secured by liens on residential and commercial
real property amounting to $1.2 million and $1.3 million at December 31,
1995 and 1994, respectively.
(2) Includes nonperforming loans of $0.4 million and $0 million at December 31,
1995 and 1994, respectively, identified in Table 1. There were no potential
nonperforming loans at December 31, 1995 identified in Table 2.
25
28
Credit Administration and Regulatory Oversight
Sound asset credit quality is important to remaining competitive for depositors
and borrowing customers, maintaining accessibility to wholesale sources of funds
at reasonable costs, and preserving capital resources.
As the Bank's principal regulator, the OCC examines and evaluates the financial
condition, operations, and policies and procedures of nationally chartered banks
on a regular basis as part of its legally prescribed oversight responsibilities.
The OCC conducted a general loan portfolio examination of the Bank in early 1991
which identified deficiencies in the Bank's loan underwriting and administration
policies and procedures. As discussed under "Regulatory Agreements," the OCC
determined the Bank required special supervisory attention. To implement this
determination, the OCC and the Bank entered into a formal regulatory agreement
on July 26, 1991 (the "Formal Agreement"). This agreement was amended and
superseded in its entirety on December 14, 1995 (the Amended Formal Agreement).
In response to the Formal Agreement, the Bank retained qualified management and
strengthened credit policies designed to minimize the level of losses and
nonperforming loans. These policies required extensive evaluation of new credit
requests and continuing stringent review of existing credits to promptly
identify and quantify evidence of deterioration of asset credit quality or
potential loss. The Company's policies for underwriting were strengthened and
credit risk analysis includes reviews of prospective borrowers' historical cash
flows and projected cash flows under adverse scenarios. For secured borrowings,
valuations of collateral contemplate the possibility of deteriorating market
values.
Based on its examinations, the OCC can direct a national bank to adjust its
financial statements in accordance with the examinations' findings.
Off-Balance Sheet Credit Commitments and Contingent Obligations
The Company is a party to financial instruments with off-balance sheet credit
risk in the normal course of business to meet the financing needs of its
customers. In addition to undisbursed commitments to extend credit under loan
facilities, these instruments include conditional obligations under standby and
commercial letters of credit. The Company's exposure to credit loss in the event
of nonperformance by customers is represented by the contractual amount of the
instruments.
Standby letters of credit are conditional commitments issued by the Company to
secure the financial performance of a customer to a third party and are
primarily issued to support private borrowing arrangements. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending loan facilities to customers. The Company uses the same credit
underwriting policies in accepting such contingent obligations as it does for
loan facilities. When deemed necessary, the Company holds appropriate collateral
supporting those commitments. The nature of collateral obtained varies and may
include deposits held in financial institutions and real properties.
Management does not anticipate any material losses as a result of commitments
under letters of credit. A portion of the allowance for loan losses has been
allocated to these contingent obligations, as presented in Table 3. Losses, if
any, are charged against the allowance for loan losses. At December 31, 1995,
Standby letters of credit amounted to $413,000 and there were no commercial
letters of credit outstanding.
Undisbursed commitments under revocable and irrevocable loan facilities amounted
to $11.6 million at December 31, 1995, including $3.6 million of such
commitments having original maturities in excess of one year. Many of these
commitments are expected to expire without being drawn upon and, as such, the
total commitment amounts do not necessarily represent future cash requirements
(see "Liquidity").
NET INTEREST INCOME AND INTEREST RATE RISK
Net Interest Income
Net interest income represents the Bank's most significant source of earnings.
The Bank's ability to generate profitable levels of net interest income is
largely dependent on its ability to maintain sound asset credit quality and
appropriate levels of capital and liquidity (see "Credit Portfolio Composition
and Credit Risk," "Capital Resources," and "Liquidity"). A financial
institution's inability to maintain strong asset credit quality, capital or
liquidity may adversely affect (i) the ability to accommodate desirable
borrowing customers, thereby inhibiting growth in higher-yielding earning
assets, (ii) the ability to attract comparatively stable, lower-cost deposits,
and (iii) the costs of wholesale funding sources.
26
29
The Bank analyzes its earnings performance using, among other measures, the
interest rate spread and net yield on earning assets. The interest rate spread
represents the difference between the interest yield received on earning assets
and the interest rate paid on interest-bearing liabilities. The net yield on
earning assets represents net interest income as a percentage of average total
earning assets. Table 6 presents the average yield on each category of earning
assets, average rate paid on each category of interest-bearing liability, and
the resulting interest rate spread and net yield on earning assets for each year
in the three-year period ended December 31, 1995. Yields on tax-exempt
investment securities presented in Table 6 have not been adjusted to a fully
taxable equivalent to recognize the income tax savings and to facilitate
comparison of taxable and tax-exempt assets because of utilized operating loss
carryforwards.
1995 Compared to 1994. Net interest income for the year ended December 31, 1995
was $7.7 million as compared to $15.4 million for the year ended December 31,
1994. The decrease is primarily attributable to declining loan balances and the
sale of securities during 1995 and the fourth quarter of 1994.
Interest earning assets at December 31, 1995 decreased to $119.6 million,
compared with $205.6 million at December 31, 1994. Interest bearing liabilities
at December 31 1995 decreased to $80.1 million, compared with $133.0 million at
December 31, 1994.
Loan interest income in 1994 included the accretion of deferred gain from the
Company's prime-based interest rate floor contract and the accretion of discount
on the purchased loans, discussed below. The net yield on earning assets and the
net interest rate spread for 1995 were 5.52% and 3.77%, respectively, as
compared to 6.77% and 5.43%, respectively, for 1994, including the effect of the
accretion of deferred gain and discounts. This is also reflected in the
decreased net interest income for 1995.
1994 Compared to 1993. Net interest income increased to $15.4 million for 1994
from $14.7 million for 1993. The increase is primarily attributed to net
accretion of discount on the loan portfolio purchased in 1993 of $3.9 million
and the accretion of the deferred gain of $544,000 from the sale of a prime rate
based floor component of an interest rate collar contract which expired in June
1994, compared to $2.2 million included in interest income in 1993 related to
the same contract.
The net yield on earning assets and the net interest rate spread for 1994 were
6.77% and 5.43%, respectively, as compared to 5.56% and 4.44%, respectively, for
1993. The effect of the accretion of discount and deferred gain enhanced
interest income by $4.4 million and minimized the effect of decline in earning
assets and the increase in the cost of funds. (See Table 6 "Average Balance
Sheets and Analysis of Net Interest Income" and Table 7 "Increase (Decrease in
Interest Income/Expense Due to Change in Average Balance and Average Rate.")
Without this income, the net yield on earning assets and net interest rate
spread would be reduced in 1994 to 4.77% and 3.43%, respectively, as compared
4.70% and 3.56%, respectively for 1993, which excludes the $2.2 million of
interest income from the interest rate swap in 1993.
Effects of Nonperforming Loans on Net Interest Income. Foregone interest income
attributable to nonperforming loans amounted to $160,000 for 1995 compared to
$1.2 million for 1994 representing a 17 basis point and an 83 basis point
reduction, respectively in yield on average gross loans outstanding for those
years. Although the Bank sold a large portion of the nonperforming loans in
February 1995, to the extent that additional loans are identified as
nonperforming in future periods, operating results will continue to be adversely
affected. (See "Credit Portfolio Composition and Credit Risk" for a discussion
of the Company's asset credit quality experience and the effects of
nonperforming loans on the provision and allowance for loan losses.)
Future Effects of Continued Decline in Loan Volume. Loan volume continued to
decline during 1995, and decreased to $82.0 million at December 31, 1995, from
$115.3 million at December 31, 1994. Average balances for 1995 totaled $95.8
million compared to $140.1 million for 1994. The volume of outstanding loans has
experienced a sustained decline since the second quarter of 1991, due to the
ongoing recession affecting the Company's primary market area, the planned
restructuring and lack of effective marketing efforts. Management believes that
a lower volume of loans will continue to adversely affect the Company's net
interest income, interest rate spread and net yield on earning assets during the
foreseeable future.
Comparison of Net Yield and Interest Rate Spread. The Company's net yield on
earning assets remains high in comparison with the interest rate spread due to
the continued significance of noninterest-bearing demand deposits relative to
total funding sources. While these deposits are noninterest-bearing, they are
not cost-free funds. Customer service expense, primarily costs related to
external accounting, data processing and courier services provided to title and
escrow company depositors, are incurred by the Company to the extent that
certain average noninterest-bearing deposits are maintained by such depositors,
and such
27
30
deposit relationships are determined to be profitable. Customer service expense
is classified as noninterest expense. If customer service expenses related to
escrow customers were classified as interest expense, the Company's reported net
interest income and noninterest expense for the years ended December 31, 1995
and 1994 would be reduced by $489,000 and $423,000, respectively. The net yield
on earning assets for the years ended December 31, 1995 and 1994 would have been
5.17% and 6.59%, respectively, as compared to the actual net yield on earning
assets of 5.52% and 6.77% for 1995 and 1994, respectively.
28
31
Table 6 Year ended December 31, 1995
Average Balance Sheets and ----------------------------------------------------------
Analysis of Net Interest Income Average Balances
---------------------------------
% Change
% of from Interest Average
Total Prior Income/ Yield/
Amount Assets Year Expense Rate
-------- ------ ------- -------- ------
(dollar amounts in thousands)
ASSETS:
Federal funds sold and securities purchased
under agreements to resell $ 16,034 11% 107% $ 933 5.82%
Interest-bearing deposits in other financial
institutions 174 0% 287% 7 4.02%
Securities held to maturity:
U.S. Treasury and agency, corporate and
other securities 0 0% -100% -- --
Tax-exempt municipal securities -- -- -- -- --
Securities available for sale:
U.S. Treasury and agency, corporate and
other securities 26,636 18% -59% 1,383 5.19%
Tax-exempt municipal securities 45 0% -86% 12 26.67%
Trading securities 0 0% -100% -- --
Loans(1)(2) 95,771 64% -32% 9,299 9.71%
-------- ----- --------
Total earning assets $138,660 93% -39% $ 11,634 8.39%
========
Nonearning assets:
Cash and due from banks -- demand 9,403 6% -42%
Other assets 4,840 3% -54%
Allowance for credit losses (3,504) -2% -57%
-------- -----
Total assets $149,399 100% -39%
======== =====
LIABILITIES AND SHAREHOLDERS' EQUITY:
Interest-bearing deposits:
Demand $ 7,341 5% -23% $ 137 1.87%
Money market and savings 29,001 19% -27% 1,002 3.46%
Time certificates of deposit:
$100,000 or more 8,876 6% -23% 542 6.11%
Under $100,000 36,754 25% -51% 2,188 5.95%
-------- ----- --------
Total time certificates of deposit 45,630 31% -47% 2,730 5.98%
-------- ----- --------
Total interest-bearing deposits 81,972 55% -39% 3,869 4.72%
Federal funds purchased and securities sold
under agreements to repurchase 4,154 3% -62% 110 2.65%
-------- ----- --------
Total interest-bearing liabilities $ 86,126 58% -41% $ 3,979 4.62%
========
Noninterest-bearing liabilities:
Noninterest-bearing demand deposits 52,246 35% -33%
Other liabilities 1,994 1% -30%
Shareholders' equity 9,033 6% -53%
-------- -----
Total liabilities and shareholders'
equity $149,399 100% -39%
======== =====
Net interest income (spread) $ 7,655 3.77%
======== ======
Excess of earning assets over interest-bearing
liabilities(2) $ 52,534 -35%
========
Net yield on earning assets 5.52%
======
Loans as a percent of total deposits
("loan-to-deposit ratio") 71.4%
========
- ------------
(1) Included in interest income on loans are net loan origination fees (costs),
representing an adjustment to yield, amounting to $312,745, $121,278 and
$63,131 in 1995, 1994 and 1993 respectively.
(2) Average balances of loans outstanding include all nonperforming loans.
32
Year ended December 31, 1994 Year ended December 31, 1993
- ---------------------------------------------------------- ----------------------------------------------------------
Average Balances Average Balances
- -------------------------------- --------------------------------
% Change Average % Change Average
% of from Interest Yield/ % of from Interest Yield/
Total Prior Income/ Rate Total Prior Income/ Rate
Amount Assets Year Expense (1) Amount Assets Year Expense (1)
- -------- ------ -------- --------- ------- -------- ------ -------- --------- -------
(dollar amounts in thousands)
7,739
$ 3% -35% $ 353 4.30% $ 11,822 4% -31% $ 375 3.17%
45 0% -92% 3 6.67% 595 0% -78% 32 5.38%
11,675 5% -85% 610 5.23% 78,716 27% 226% 4,646 5.90%
-- -- -100% -- -- 496 -- -- 50 9.67%
64,252 26% 682% 3,625 5.64% 8,216 3% -75% 314 3.82%
326 0% -28% 50 14.89% 450 0% -86% 45 9.59%
2,895 1% -52% 130 4.49% 6,038 2% 352% 217 3.59%
140,079 57% -12% 16,149 11.53% 159,680 55% -17% 14,933 9.35%
- -------- ---- -------- -------- ---- --------
$227,009 92% -15% $ 20,900 9.21% $266,011 91% -3% $ 20,612 7.75%
======== ========
16,203 7% -26% 21,934 8% 15%
10,515 4% -3% 10,794 4% 6%
(8,172) -3% 8% (7,573) -3% -7%
- -------- ---- -------- ----
$245,555 100% -16% $291,166 100% -1%
======== ==== ======== ====
$ 9,493 4% -28% $ 144 1.52% $ 13,199 5% 2% $ 171 1.29%
39,852 16% -17% 1,274 3.20% 47,905 16% -13% 1,301 2.72%
11,481 5% -27% 471 4.11% 15,815 5% -29% 562 3.55%
74,484 30% -13% 3,309 4.44% 85,410 30% 10% 3,534 4.14%
- -------- ---- -------- -------- ---- --------
85,965 35% -15% 3,780 4.40% 101,225 35% 1% 4,096 4.05%
- -------- ---- -------- -------- ---- --------
135,310 55% -17% 5,198 3.84% 162,329 56% -3% 5,568 3.43%
10,863 5% -23% 328 3.02% 14,029 5% -26% 352 2.51%
- -------- ---- -------- -------- ---- --------
$146,173 60% -17% $ 5,526 3.76% $176,358 61% -6% $ 5,920 3.36%
======== ========
77,445 32% -14% 89,605 31% 14%
2,851 1% -16% 3,490 1% -20%
19,086 7% -12% 21,713 7% -12%
- -------- ---- -------- ----
$245,555 100% -16% $291,166 100% -1%
======== ==== ======== ====
$ 15,374 5.43% $ 14,692 4.44%
======== ====== ======== ======
$ 80,836 -10% $ 89,653 4%
======== ========
6.77% 5.56%
====== ======
65.8% 63.4%
======== ========
30
33
Table 7
Increase (Decrease) in Interest Income/Expense
Due to Change in Average Balance and Average Rate(1)
Year ended December 31, Year ended December 31, Year ended December 31,
1995 Compared to 1994 1994 Compared to 1993 1993 Compared to 1992
--------------------------- --------------------------- ---------------------------
Balance Rate Total Balance Rate Total Balance Rate Total
------- ------- ------- ------- ------- ------- ------- ------- -------
(Dollar amounts in thousands)
INTEREST INCOME:
Federal funds sold and
securities purchased under
agreements to resell $ 357 $ 243 600 $ (178) $ 136 $ (42) $ (160) $ (30) $ (190)
Interest-bearing deposits in
other financial institutions 9 (5) 4 (30) 1 (29) (108) 20 (88)
Securities held to maturity:
U.S. Treasury and agency,
corporate and other
securities (610) 0 (610) (3,765) (271) (4,036) 3,134 (237) 2,897
Tax-exempt municipal
securities 0 0 0 (50) -- (50) 50 -- 50
Securities available for sale:
U.S. Treasury and agency,
corporate and other
securities (2,122) (119) (2,241) 3,067 244 3,311 (1,038) (638) (1,676)
Tax-exempt municipal
securities (42) 5 (36) (15) 20 5 (281) 35 (246)
Trading securities (130) 0 (130) (132) 45 (87) 169 4 173
Loans (5,109) (1,743) (6,852) (1,980) 3,196 1,216 (3,069) 184 (2,885)
------- ------- ------- ------- ------- ------- ------- ------- -------
Total earning assets $(7,647) $(1,619) $(9,266) $(3,083) $ 3,371 $ 288 $(1,303) $ (662) $(1,965)
======= ======= ======= ======= ======= ======= ======= ======= =======
INTEREST EXPENSE:
Interest-bearing deposits:
Demand $ (33) $ 26 $ (7) $ (53) $ 26 $ (27) $ 6 $ (99) $ (93)
Money market and savings (347) 74 (273) (234) 207 (27) (230) (263) (493)
Time certificates of deposit:
$100,000 or more (107) 177 70 (169) 78 (91) (259) (185) (444)
Under $100,000 (1,675) 556 (1,119) (474) 249 (225) 363 (733) (370)
------- ------- ------- ------- ------- ------- ------- ------- -------
Total time certificates of
deposit (1,782) 733 (1,049) (643) 327 (316) 104 (918) (814)
------- ------- ------- ------- ------- ------- ------- ------- -------
Total interest-bearing
deposits (2,162) 833 (1,329) (930) 560 (370) (120) (1,280) (1,400)
Federal funds purchased and
securities sold under
agreements to repurchase (203) (15) (218) (115) 91 (24) (149) (152) (301)
Other short-term borrowings -- -- -- -- -- -- -- -- --
------- ------- ------- ------- ------- ------- ------- ------- -------
Total interest-bearing
liabilities $(2,365) $ 818 $(1,547) $(1,045) $ 651 $ (394) $ (269) $(1,432) $(1,701)
======= ======= ======= ======= ======= ======= ======= ======= =======
Net interest income $(5,282) $(2,437) $(7,719) $(2,038) $ 2,720 $ 682 $(1,034) $ 770 $ (264)
======= ======= ======= ======= ======= ======= ======= ======= =======
- ---------------
(1) The change in interest income or interest expense that is attributable to
both changes in average balance and average rate has been allocated to the
changes due to (i) average balance and (ii) average rate in proportion to
the relationship of the absolute amounts of the changes in each.
31
34
Interest Rate Risk Management
Interest rate risk management focuses on controlling changes in net interest
income that result from fluctuating market interest rates as they impact the
rates earned and paid on earning assets and interest-bearing liabilities whose
interest rates are subject to change prior to their maturity. Net interest
income is subject to fluctuations arising from changes in market interest rates
to the extent that the yields on various categories of earning assets respond
differently to such changes as compared to interest rate-sensitive funding
sources.
As part of the Company's efforts to manage interest rate risk, the Finance and
Investment Committee of the Board of Directors meets monthly to review the
exposure of earnings to potential changes in market interest rates.
Hedging Contracts. The Company's ability to manage interest rate risk using an
on-balance sheet approach (such as offering loan and deposit products with
varying terms and pricing characteristics) is limited by competitive factors and
customer options. As a result, the Company's management of interest rate risk
previously used off-balance sheet techniques, including interest rate swap
agreements and collar and floor contracts. Interest rate swap transactions
involve the exchange of fixed and floating rate interest payment obligations
without the exchange of the underlying notional (principal) amounts. In exchange
for a premium, interest rate collar and floor contracts provide for the
purchaser's (seller's) receipt (payment) of interest on the notional amount of
the contract to the extent that a specified index interest rate declines below
(rises above) a fixed rate established in the contract.
In December 1994, the Bank entered into an interest rate swap contract. Under
the terms of the agreement the Bank received a floating U.S. libor rate, initial
rate of 6.8%, and paid an 8.2% fixed rate. Payments were calculated on a $30
million notional amount based on a three year term to be paid semi annually. The
original expiration of the contract was March 31, 1995, and was subsequently
extended to July 31, 1995. The swap was intended to hedge the market value
fluctuations of investment securities available-for-sale and was therefore
recorded at its fair value at December 31, 1994. The unrealized gain of $135,000
at December 31, 1994 was recorded with the unrealized gain/loss on securities
available-for-sale. The swap was terminated in 1995 with a realized loss of $1.3
million.
In October 1993, the Bank entered into an interest rate swap contract. Under the
terms of the agreement, the Bank received 6.0% fixed and paid floating-rate
prime for 21 months on a $10 million notional amount. The swap was intended to
bring the Bank's interest rate sensitivity "gap" back within policy guidelines
for interest rate risk exposure. The Bank had moved slightly outside of these
guidelines during the third quarter of 1993, primarily due to the September 7,
1993, $20.8 million loan purchase which consisted of almost all floating-rate
prime based loans. This contract matured in August, 1995.
During 1994, the Company recognized $544,000 in interest income from loans which
represented the accretion of a deferred gain resulting from the sale of a prime
rate based floor component of an interest rate collar contract that expired in
June 1994.
The interest rate swap agreements and floor contract were entered into to reduce
the effects on loan interest income and net interest income from potential
changes in interest rates generally and the prime interest rate in particular.
At December 31, 1995, the Company's loan portfolio included $53.4 million of
loans having interest rates that float, primarily with changes in the prime
interest rate, representing 68.2% of total gross loans outstanding at that date.
The Company and the Bank did not have any open contracts at December 31, 1995.
Interest Rate Maturities of Assets and Funding Sources. Management also monitors
the sensitivity of net interest income to potential interest rate changes by
distributing the interest rate maturities of assets and supporting funding
liabilities into interest rate-sensitivity periods, summarizing interest rate
risk in terms of the resulting interest rate-sensitivity "gaps," as presented in
Table 8. A positive gap indicates that more assets than funding sources are
subject to repricing during a specified period (asset-sensitive), while a
negative gap (liability-sensitive) indicates the opposite condition. Balance
sheet items are categorized in Table 8 according to their contractual repayment
terms or earliest possible repricing dates, as appropriate. Determining the
interest rate-sensitivity of noncontractual items is determined in a more
qualitative manner, giving recognition to historical experience and expectations
related to such factors as competitive conditions, disintermediation, and
customer options (such as assets subject to prepayments and deposits subject to
early withdrawal or immediate availability).
The gap position is but one of several variables that affect net interest
income. The gap measure is a static indicator and, as such, is not an
appropriate means for forecasting changes in net interest income in a dynamic
business and economic environment. Consequently, these measures are not used in
isolation by management in forecasting short-term changes in net interest
income.
32
35
Table 8
Interest Rate Maturities of Assets and
Funding sources at December 31, 1995
Amounts Maturing or Repricing in
----------------------------------------------------------------------
After
After one year
three months but
Less than but within within After Not Rate
three months one year 5 years 5 years Sensitive Total
------------ ------------ -------- ------- -------- --------
(dollar amounts in thousands)
ASSETS:
Federal Funds sold and securities purchased under
agreements to resell $ 21,000 $ -- $ -- $ -- $ -- $ 21,000
Investment securities held-for-sale -- 4,009 6,749 9,659 -- 20,417
Loans, net 47,463 14,149 14,371 2,224 -- 78,207
------- ------- ------- ------- -------- --------
Total earning assets 68,463 18,158 21,120 11,883 0 119,624
Non-earning assets
Cash and due from banks -- -- -- -- 9,272 9,272
Other real estate owned -- -- -- -- 581 581
All other assets -- -- -- -- 2,515 2,515
------- ------- ------- ------- -------- --------
Total assets 68,463 18,158 21,120 11,883 12,368 131,992
LIABILITIES & SHAREHOLDERS' EQUITY:
Interest bearing Deposits:
Interest-bearing demand, money market and
savings 28,565 -- -- -- -- 28,565
Time certificates of deposit 12,577 15,749 18,773 -- -- 47,099
Federal funds purchased and securities sold under
agreements to repurchase 4,497 -- -- -- -- 4,497
------- ------- ------- ------- -------- --------
Total Interest bearing liabilities 45,639 15,749 18,773 0 0 80,161
Non-Interest bearing liabilities:
Non-Interest bearing deposits -- -- -- -- 44,579 44,579
Other liabilities -- -- -- -- 1,241 1,241
Shareholders' equity -- -- -- -- 6,011 6,011
------- ------- ------- ------- -------- --------
Total liabilities & shareholders equity 45,639 15,749 18,773 0 51,831 131,992
------- ------- ------- ------- -------- --------
Interest rate-sensitivity gap $22,824 $ 2,409 $ 2,347 $11,883 $(39,463) $ 0
======= ======= ======= ======= ======== ========
Cumulative interest rate-sensitivity gap $22,824 $25,233 $27,580 $39,463 0 0
======= ======= ======= ======= ======== ========
Cumulative rate sensitivity gap as a percent of
cumulative earning assets 33% 29% 26% 33%
======= ======= ======= =======
Table 9
Maturities and Sensitivities of Loans
to Changes in Interest Rates December 31, 1995
Interest Interest
rates are rates are
floating fixed or
or adjustable predetermined Total
------------- ------------- -------
(dollar amounts in thousands)
Aggregate maturities of net loan balances which are due(1):
In one year or less $53,333 $ 8,279 $61,612
After one year but within five years 43 14,328 14,371
After five years -- 2,224 2,224
------- ------- -------
Total $53,376 $24,831 $78,207
======= ======= =======
- ---------------
(1) Scheduled repayments are reported in the maturity category in which the
payments are due, based on the loans' contractual terms, without regard to
any potential renewals (rollovers) of such loans. The Company may renew
loans upon their maturity, pursuant to credit underwriting guidelines
established for all extentions of credit (see "Credit Portfolio Composition
and Credit Risk").
33
36
(LOSS) GAINS ON SALES OF SECURITIES
1995 Compared to 1994
The Company continued to reduce asset size through restructuring the securities
portfolio during 1995, as discussed below. During 1995, the Bank sold $46.9
million of investment securities available for sale, and terminated a related
interest rate swap contract, realizing a net loss of $1.2 million on the sale of
securities and a loss of $1.3 million on the termination of the interest rate
swap contract. The 1994 losses on sales of securities were $1.4 million, mainly
in the fourth quarter of that year. The net unrealized loss on securities
available for sale decreased by $2.9 million during the year ended December 31,
1995, primarily as a result of the sale of securities and the realization of
related losses, as compared to an increase in net unrealized losses on
securities available for sale of $3.5 million during the year ended December 31,
1994.
1994 Compared to 1993
The Company's plan to reduce asset size through restructuring the securities
portfolio included the sale of the securities available-for-sale that were
funded by high rate deposits in order to minimized future interest rate risk and
decrease volatile liability dependency. In the fourth quarter of 1994 there were
approximately $80.0 million of securities, yielding on an amortized cost basis
approximately 5.5%, that were funded by high cost deposits with maturities
through the second quarter of 1995. The Bank sold approximately $30.0 million of
these securities in the fourth quarter and realized a loss of $1.3 million.
The Bank's plan is to maintain a securities available-for-sale portfolio of
approximately $20.0 million to $30.0 million on a reduced assets base to provide
a source of liquidity and to meet the needs of pledged collateral for retail
customers repurchase agreements and other deposits as required.
Loss on trading securities totaled $112,000 for 1994 as compared to net gains of
$43,000 for 1993. Activity in trading securities ceased during 1994 and
management does not intend to engage in this activity in the foreseeable future.
As discussed further under "Repurchase Agreements," the Company pledges certain
securities as collateral for retail (customer) repurchase agreements and other
deposits, as required. At December 31, 1995, total securities pledged amounted
to $7.5 million. The Company may pledge additional securities as collateral for
borrowings against wholesale (dealer) repurchase agreements to the extent such
agreements become necessary to meet future liquidity needs.
34
37
Table 10
Maturities of and Weighted Average Yields on Investment
Securities and Debt Securities Available for Sale
December 31, 1995
-----------------------------------------------------------------------------------------
Carrying amount of investment securities maturing
--------------------------------------------------------------------
After five
After one but but
Within one within five within ten After ten
year years years years
------------- ------------- ------------- --------------
Amount Yield Amount Yield Amount Yield Amount Yield Total Yield
------ ----- ------ ----- ------ ----- ------ ------ ------- -------
(dollar amounts in thousands)
Debt securities available
for sale:
U.S. Treasury Securities $1,010 5.02% -- -- $ -- -- $ -- -- $ 1,010 5.02%
GNMA-guaranteed mortgage
pass-through securities -- -- 120 6.01% -- -- -- -- 120 6.01%
FHLMC-issued mortgage pass-
through certificates -- -- -- -- -- -- 5,971 6.24% 5,971 6.24%
Other government sponsored
agency securities 2,999 4.99% 6,629 5.06% -- -- -- -- 9,628 5.04%
CMO's and REMIC's issued by
U.S. Gov't sponsored
agencies -- -- -- -- -- -- 3,373 5.54% 3,373 5.54%
Federal Reserve Bank Stock -- -- -- -- -- -- 315 6.00% 315 6.00%
------ ------ ------ ------ -------
$4,009 5.00% $6,749 5.08% $ -- -- $9,659 5.99% $20,417 5.49%
====== ====== ====== ====== =======
Estimated Fair Values of and Unrealized Gains and Losses on
Investment Securities and Debt Securities Available-for-Sale
December 31, 1995
-------------------------------------------------------
Total Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value Yield
--------- ---------- ---------- --------- -----
(dollar amounts in thousands)
Debt Securities Available-for-Sale:
U.S. Treasury securities $ 1,010 $ -- $ -- $ 1,010 5.02%
GNMA-guaranteed mortgage pass-through
securities 119 1 -- 120 6.01%
FHLMC-issued mortgage pass-through
certificates 6,001 11 41 5,971 6.24%
Other government sponsored agency
securities 9,683 -- 55 9,628 5.04%
CMOs and REMICs issued by:
U.S. Govt. agencies 3,443 -- 70 3,373 5.54%
Privately issued -- -- -- -- --
Zero coupon revenue municipal
securities: -- -- -- -- --
Federal Reserve Bank Stock 315 -- -- 315 6.00%
Interest Rate Swap -- -- -- -- --
-------- ---- ---- --------
$ 20,571 $ 12 $166 $ 20,417 5.49%
======== ==== ==== ========
December 31, 1994
-------------------------------------------------------
Total Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value Yield
--------- ---------- ---------- --------- -----
(dollar amounts in thousands)
Debt Securities Available-for-Sale:
U.S. Treasury securities $ 12,000 $ 4 $ 55 $ 11,949 6.84%
GNMA-guaranteed mortgage pass-through
securities 5,325 33 255 5,103 6.17%
FHLMC-issued mortgage pass-through
certificates 7,362 -- 253 7,109 5.58%
Other government sponsored agency
securities 14,869 -- 906 13,963 5.89%
CMOs and REMICs issued by:
U.S. Govt. agencies 23,353 2 1,688 21,667 6.37%
Privately issued 1,532 -- 59 1,473 6.41%
Zero coupon revenue municipal
securities: 99 -- 15 84 10.00%
Federal Reserve Bank Stock 573 -- -- 573 6.00%
Interest Rate Swap -- 135 -- 135
-------- ---- ------ --------
$ 65,113 $174 $3,231 $ 62,055 6.24%
======== ==== ====== ========
OTHER OPERATING INCOME
As set forth in the accompanying consolidated statements of operations, the
Company's principal sources of recurring other operating income currently are
letters of credit and foreign exchange services, investment services and
deposit-related and other customer services.
1995 Compared to 1994
Other operating income from international services, investment services, and
deposit related and other customer services for the year ended December 31, 1995
decreased $199,000 or 14.1% from the year ended December 31, 1994, resulting
primarily from decreases in international services. Other income for the year
ended December 31, 1995 included $730,000 in income from insurance proceeds
resulting from the settlement of a law suit. Other operating income (loss) for
the year ended December 31, 1994 included a loss of $1.1 million on the
write-down of a movie library received as collateral for a loan.
Income from international services decreased by 48.5% for the year ended
December 31, 1995 as compared to the year ended December 31, 1994. The
department was closed in December, 1995, while retaining the letter of credit
and foreign exchange functions.
35
38
1994 Compared to 1993
Total other operating income, excluding net (losses)gains on sales of
securities, losses on other real estate owned and other assets and the lower of
cost or market adjustment on loans held for sale, decreased to $1.4 million for
1994 from $1.6 million for 1993. Income from international services decreased by
22.7% to $435,000 for 1994 from $563,000 for 1993. The decrease was attributed
to lower volume of foreign exchange transactions in 1994 as compared to 1993.
Income from investment services increased by 17.4% to $283,000 from $241,000.
The Bank's investment services operation offers a range of investment products
to the Bank's customers, including mutual funds, annuities and certain life
insurance products. Management believes its investment services operation will
be a growing source of revenue for the Bank.
Income from deposit-related and other customer service decreased by 12.4%, to
$696,000 for 1994 from $795,000 for 1993. This decrease can be attributed to the
declining average balance of noninterest deposits. Average noninterest deposits
for 1994 decreased by 14.0%.
OTHER OPERATING EXPENSE
1995 Compared to 1994. Other operating expenses decreased 18.1% for the year
ended December 31, 1995 as compared to the year ended December 31, 1994. The
decrease was due primarily to management's efforts to continue to reduce
operating expenses. Compensation expense decreased $1.4 million or 25.9% for the
year ended December 31, 1995 as compared to the year ended December 31, 1994.
Other operating expenses decreased in all categories except for customer service
expenses which increased $16,000 or 1.9% and other professional services which
increased $140,000 or 10.0%. The increase in customer services expenses were
attributable to increased data processing costs associated with escrow account
customers, and the increase in other professional services were attributable to
accounting and auditing fees and the use of outside consultants to supplement
management.
As of December 31, 1995, the Bank entered into a Lease Restructure Agreement
with its landlord, which modified the Bank's future lease obligations by
substantially reducing its rent expense. As a result of the Lease Modification,
the Bank reduced its space under its leases from approximately 42,400 square
feet to 23,883 square feet. Further, the Lease Modification resulted in a
decrease in the effective rent per square foot from approximately $4.00 to $2.33
or $55,666 per month for the period November 1, 1995 to October 31, 2000. The
effective rent for the period November 1, 2000 to October 31, 2004 will be $2.83
per square foot or $67,607 per month and 1996 is the base year for increases in
property taxes and operating costs resulting in a further decline of operating
expenses and a limit on annual increases. For the year 1996, pass through
expenses will be zero. The restructuring of the Bank's leases represents an
annual savings of $852,000 over the next five years.
Under the provisions of the Lease Restructure Agreement, the Bank assigned its
interests in its subleases to the landlord. In conjunction with the execution of
the Lease Restructure Agreement, the Company has issued to the landlord a seven
year warrant to purchase up to 9.9% of the shares of the Company's common stock
at $1.50 per share (or such lower price as provided in the Warrant Agreement).
The Company also granted the landlord registration rights with respect to any
shares purchased by the landlord (or its assignee) pursuant to the Warrant.
1994 Compared to 1993. As indicated in the accompanying consolidated statements
of operations, total other operating expenses decreased $344,000 to $13.7
million for 1994 from $14.1 million for 1993. The decrease in operating expenses
resulted from management's efforts to continue to reduce operating expenses.
Reductions in expenses aggregating $1.2 million were incurred in all expense
categories except for severance cost, customer services, other professional
services, and promotion and other expenses, which totaled an aggregate increase
of $829,000. The increase in the expense categories were for the most part, the
results of specific actions and are not intended to be ongoing.
Operations in 1996 and beyond will benefit from the substantial reductions in
operating costs achieved so far. The reduction in rent expense as a result of
the restructuring of the leases, the reduction in compensation expense as a
result of the reduction in staff, and the reduction in other non-interest
expense will contribute directly to the improved performance of future years.
Expenses in each of these areas is expected to be at levels even lower than
those in 1995. An 18.3% reduction in staff in December, 1995 represents an
annual savings of $810,000.
36
39
INCOME TAXES
The Company utilized all available financial statement income tax benefits in
1991, therefore, the cumulative losses through December 31, 1994, resulted in
income tax carryforwards for the Company. The Company has recognized losses for
financial statement purposes which have not yet been recognized on an income tax
return. At December 31, 1995, the Company had $23.5 million of financial
statement net operating loss carryforwards and $21.5 million of income tax net
operating loss carryforwards. Future losses will not result in income tax
benefits to the Company until it generates sufficient taxable income to utilize
the present net operating loss carryforwards. The Company has maximized its
carryback potential for federal income tax purposes.
The Company filed a loss carryback claim in 1995 and received a refund amounting
to $535,000 plus $43,000 in interest in 1996.
Federal income tax laws permit the Company to carry back net operating losses
three years to offset taxable income in those periods, if any, and forward
fifteen years to offset taxable income in those future periods. Under special
circumstances losses may be carried back up to 10 years. California franchise
tax laws do not provide for the carryback of such losses and generally permit
one-half of net operating losses to be carried forward five years.
CAPITAL RESOURCES
The Company's shareholders' equity at December 31, 1995, decreased to $6.0
million from $10.3 million at December 31, 1994. The decrease is attributed to
the current year's net loss of $7.2 million net of a decrease in unrealized
losses on the securities available-for-sale of $2.9 million.
The ability of the Company and the Bank to maintain appropriate levels of
capital resources is substantially dependent on their ability to support earning
assets and sustain profitability. The Company's plan for 1996 is to further
improve profitability by improving asset quality by reducing nonperforming
loans, continuing to reduce operating expenses, and increasing fee revenues.
Although the Company and Bank have taken steps toward these goals, there can be
no assurances that operating losses will not continue.
The Bank is currently operating under a Formal Agreement dated December 14, 1995
with the OCC. To the extent significant losses continue and capital continues to
erode, the Bank could fall into an "undercapitalized" category. In such event,
the Bank would be even more closely monitored by the federal regulators, and
could be subject to other restrictions. (See Item 1. "BUSINESS -- Federal
Deposit Insurance Corporation Improvement Act of 1991.")
REGULATORY CAPITAL REQUIREMENTS
Risk-Based Capital Guidelines
The Federal Reserve Board and the OCC have issued guidelines to implement
risk-based capital requirements. These requirements are discussed in detail
under "Item 1. BUSINESS -- Capital Adequacy Guidelines."
The risk-based capital ratio of the Company and the Bank are calculated under
the guidelines by dividing their respective qualifying total capital by their
respective total risk-weighted assets. The Company's qualifying total capital
and total risk-weighted assets are determined on a fully consolidated basis. A
bank holding company's total qualifying capital is comprised of the sum of core
capital elements ("Tier 1 capital") and supplementary capital elements ("Tier 2
capital"), minus certain specified deductions (collectively, the "deductions"),
if any. The Company and the Bank's Tier 1 capital consists of common
shareholders' equity. Tier 1 capital excludes any net unrealized gains or losses
resulting from the implementation of Statement of Financial Accounting Standard
(SFAS) No. 115. The Bank's Tier 2 capital consists of the allowance for credit
losses (subject to overall limitations as discussed under "Item 1.
Business -- Capital Adequacy Guidelines"). The Company has no Tier 2 capital.
The risk-based capital ratio focuses principally on broad categories of credit
risk. The ratio does not take into account many other factors that can affect
the Company's or the Bank's financial condition. Those factors include interest
rate risk, liquidity risks, the levels and quality of earnings, investment or
loan portfolio concentrations, the quality of loans and investments, the
effectiveness of lending and investment policies, and management's overall
ability to monitor and control financial and operating risks. In addition to
evaluating capital ratios, an overall assessment of capital adequacy will take
into account each of those other factors, including, in particular, the level of
nonperforming and potential nonperforming loans. For these reasons, the final
37
40
supervisory judgment on a banking organization's capital adequacy may differ
from the conclusions that may be drawn solely from the entity's risk-based
capital ratio. Accordingly, the FRB and OCC generally expect bank holding
companies and national banks to operate with risk-based capital ratios above the
minimums required.
Capital Leverage Ratio Standards
The Federal Reserve Board and the OCC require a minimum leverage ratio of Tier 1
Capital to total assets of 4.0%. Institutions experiencing or anticipating
significant growth or those with other than minimum risk profiles will be
expected to maintain capital well above the minimum levels.
Formal Agreement
As discussed further under "Regulatory Agreements," the Bank entered into the
Formal Agreement with the OCC on December 14, 1995, pursuant to which the Bank
is required to achieve and maintain, (i) a capital leverage ratio equal to at
least 6.5% and (ii) a Tier 1 capital to risk weighted assets ratio equal to at
least 10.0%. As set forth in Table 11, the Bank's capital leverage and Tier 1
capital to risk weighted assets ratios at December 31, 1995, were 4.67% and
6.95%, respectively. At December 31, 1995, the Bank was not in compliance with
maintaining a capital leverage ratio of 6.5% or a Tier 1 capital to risk
weighted assets ratio of 10% pursuant to the Amended Formal Agreement.
Accordingly, the Bank may be subject to further regulatory enforcement action by
the OCC. A Capital Plan was filed with the OCC on February 8, 1996.
In addition, the Agreement restricts the ability of the Company and the Bank to
declare and pay dividends.
Failure to comply with the Formal Agreement can result in further regulatory
action such as a cease and desist order, the imposition of civil money penalties
against the Bank and its directors and executive officers or the removal of one
or more directors or executive officers.
Table 11
Regulatory Capital Information of the Company
and the Bank at December 31, 1995 and 1994
1995 1994
------------------------------------ ------------------------------------
Company Bank Company Bank
---------------- ---------------- ---------------- ----------------
Amount Ratio Amount Ratio Amount Ratio Amount Ratio
-------- ----- -------- ----- -------- ----- -------- -----
(dollar amounts in thousands)
Risk-based capital(3):
Tier 1 capital $ 6,166 6.96% $ 6,157 6.95% $ 13,365 9.84% $ 13,304 9.80%
Tier 1 capital minimum requirement 3,542 4.00% 8,856 10.00%(1) 5,431 4.00% 5,431 4.00%
-------- ----- -------- ----- -------- ----- -------- -----
Excess $ 2,624 2.96% $ (2,699) (3.05%) $ 7,934 5.84% $ 7,873 5.80%
======== ===== ======== ===== ======== ===== ======== =====
Total capital $ 7,306 8.25% $ 7,297 8.24% $ 15,079 11.11% $ 15,018 11.06%
Total capital minimum requirement 7,085 8.00% 7,085 8.00% 10,862 8.00% 13,578 10.00%
-------- ----- -------- ----- -------- ----- -------- -----
Excess $ 221 0.25% $ 212 0.24% $ 4,217 3.11% $ 1,440 1.06%
======== ===== ======== ===== ======== ===== ======== =====
Total risk-weighted assets $ 88,558 $ 88,558 $135,777 $135,777
Capital Leverage Ratio
Standard(2)(3):
Tier 1 capital $ 6,166 4.68% $ 6,157 4.67% $ 13,365 5.65% $ 13,304 5.62%
Tier 1 capital minimum
requirement(1) 5,271 4.00% 8,565 6.50%(1) 9,461 4.00% 15,374 6.50%
-------- ----- -------- ----- -------- ----- -------- -----
Excess (Deficiency) $ 895 0.68% $ (2,408) (1.83%) $ 3,904 1.65% $ (2,070) (0.88%)
======== ===== ======== ===== ======== ===== ======== =====
Average total assets, as adjusted,
during three-month periods ended
December 31, $131,764 $131,764 $236,526 $236,526
- ------------
(1) The Bank's minimum Tier 1 capital to risk weighted assets and Tier 1 capital
leverage requirements are based on the provisions of the Formal Agreement,
which became effective on December 14, 1995.
(2) The regulatory capital leverage ratio represents the ratio of Tier 1 capital
at December 31, 1995 and December 31, 1994 to average total assets during
the three-month period then ended.
(3) Tier 1 capital excludes any unrealized gains or losses recorded under
Statement of Financial Accounting Standards No. 115.
38
41
FUTURE EFFECTS OF NONPERFORMING LOANS AND CREDIT LOSSES ON CAPITAL RESOURCES
The significant losses incurred during 1995 and 1994 eroded the Company's
capital. These losses were primarily a result of increased provisions for loan
losses, losses on securities, OREO and other assets, and reductions in interest
earning assets without a corresponding reduction in operating expenses. Although
the Company was able to decrease the level of nonperforming assets at December
31, 1995, it suffered significant loan losses related to the high level of
nonperforming loans from the previous years. To the extent that such
nonperforming loan levels increase and result in increased provisions for credit
losses and loan charge-offs or adversely affect the level of income from those
loans, the Company's ability to generate adequate future earnings will be
negatively affected.(See "Net Interest Income and Interest Rate Risk.")
EFFECTS OF REGULATORY AGREEMENTS AND RESTRICTIONS ON CASH DIVIDENDS
There are statutory and regulatory limitations on the amount of cash dividends
which may be distributed by a national bank (see Note 14 of the accompanying
notes to consolidated financial statements). As a result of those limitations
and reported net losses in 1990, 1991, 1992, 1994 and 1995 the Bank cannot under
the Formal Agreement declare dividends to the Company without the prior approval
of the OCC.
Management expects the Formal Agreement will substantially impair the ability of
the Bank to declare and pay dividends to the Company during the foreseeable
future, since the Bank currently intends to retain any earnings to augment its
regulatory capital. Since dividends from the Bank are the principal source of
income to the Company, it is unlikely that the Company will declare and pay
dividends in the foreseeable future. Further, in accordance with the Memorandum
of Understanding, the Company has agreed to refrain from paying dividends
without the prior written approval of the FRBSF and the OCC.
39
42
LIQUIDITY
LIQUIDITY MANAGEMENT
The Bank
Market and public confidence in the financial strength of the Bank and financial
institutions in general will largely determine the Bank's access to appropriate
levels of liquidity. This confidence is significantly dependent on the Bank's
ability to maintain continued sound asset credit quality and appropriate levels
of capital resources (see "Credit Portfolio Composition and Credit Risk" and
"Capital Resources"). The financial difficulties of financial institutions in
recent years have served to test this public confidence, as evidenced by recent
disintermediation (industry-wide withdrawal) of deposits.
Liquidity is defined as the ability of the Bank to meet anticipated customer
demands for funds under credit commitments and deposit withdrawals at a
reasonable cost and on a timely basis. Management measures the Bank's liquidity
position by giving consideration to both on- and off-balance sheet sources of
and demands for funds on a daily and weekly basis.
Sources of liquidity include cash and cash equivalents, net of federal
requirements to maintain reserves against deposit liabilities; investment
securities eligible for pledging to secure borrowings from dealers and customers
pursuant to securities sold under agreements to repurchase ("repurchase
agreements"); loan repayments; deposits, net of volatile noninterest-bearing
demand deposits and certain interest rate-sensitive deposits; and borrowings
under informal overnight federal fund lines available from correspondent banks.
In addition to volatile noninterest-bearing demand and interest rate-sensitive
deposits, the Bank's principal demand for liquidity is anticipated fundings
under credit commitments to customers.
In response to the Formal Agreement and the Amended Formal Agreement, the Bank's
Board of Directors adopted revised measurement guidelines for management of the
Bank's liquidity position (the "liquidity guidelines"), including limitations on
the maximum acceptable ratios as follows: (i) loan-to-deposit ratio of 85%, (ii)
amounts of purchased funds as a percentage of aggregate funding sources,
comprised of purchased funds, deposits, and borrowings from customers under
retail repurchase agreements ("purchased funds ratio") of 20%, (iii) pledged
investment securities as a percentage of the total investment securities
portfolio ("pledged securities ratio") of 75%, (iv) money desk deposits, as
discussed further below, in the aggregate and as a percentage of total deposits
of 40% and time certificates of deposit of $100,000 or more to total deposits of
15% (See "Regulatory Agreements"). For this purpose, purchased funds include
borrowings from securities dealers under wholesale repurchase agreements,
borrowings from correspondent banks under overnight federal fund lines and
brokered deposits. The liquidity guidelines further establish a minimum net
liquidity position to be maintained by the Bank. The Bank was in compliance with
these guidelines throughout 1995. (See Item 8. "CONSOLIDATED FINANCIAL
STATEMENTS.")
As described above, maintaining appropriate levels of capital is an important
factor in determining the availability of critical sources of liquidity.
Accordingly, the liquidity guidelines also require that the Bank maintain a
minimum level of total regulatory capital in excess of the minimum level
required under the FRB's guidelines (see "Capital Resources").
Management and the Finance and Investment Committee of the Board of Directors of
the Bank seek to maintain a stable net liquidity position while optimizing
operating results, as reflected in net interest income, the net yield on earning
assets and the cost of interest-bearing liabilities in particular (see "Net
Interest Income and Interest Rate Risk"). The Committee meets monthly to review
the Bank's current and projected net liquidity position and to review actions
taken by management at its weekly Liquidity Committee meetings in order to
achieve this liquidity objective.
The Company's consolidated statements of cash flows included in the accompanying
consolidated financial statements present certain information about cash flows
from operating, investing and financing activities. The Company's principal cash
flows relate to investing and financing activities of the Bank, rather than
operating activities. While the statement presents the periods' net cash flows
from lending and deposit activities, it does not reflect certain important
aspects of the Bank's liquidity described above, including (i) anticipated
liquidity requirements under outstanding credit commitments to customers, (ii)
intraperiod volatility of deposits, particularly fluctuations in the volume of
commercial customers' noninterest-bearing demand deposits, and (iii) unused
borrowings available under federal funds lines, repurchase agreements, and other
arrangements. As such, management believes that the measurements provided in the
liquidity guidelines discussed above are generally more indicative of the Bank's
overall liquidity position. The Bank's principal source of operating cash flows
is net interest income. See "Net Interest Income and Interest Rate Risk" for a
discussion of the impact of recent trends and events on this source of operating
cash flows during the three-year period ended December 31, 1995.
40
43
The Company
The Company's liquidity is limited. The Company is relying on equity sales and
dividends from the Bank as sources of liquidity. Dividends from subsidiaries
ordinarily provide a source of liquidity to a bank holding company. The Bank is
prohibited from paying cash dividends without the prior written consent of the
OCC and FRBSF.
During 1995, the Company did not receive dividends.
The Company anticipates cash expenditures during 1996 to consist of operating
expenses. A cash shortfall is anticipated unless additional cash can be raised.
(See "Regulatory Agreement")
DEPOSIT TRENDS
As indicated in Table 12, the Bank experienced a 36.9% decline in average total
deposits in 1995 from 1994. The decline in deposits occurred throughout various
deposit categories as the mix of deposits during 1995 did not significantly
change from 1994 except for the decrease in money desk operations, which was a
planned reduction.
The deposit decline continued subsequent to December 31, 1995, as Table 12
presents average deposits for the two months ended February 29, 1996, of $115.3
million compared to the previous calendar quarter of $120.2 million. The
percentage mix of deposits remained comparable. The reductions were consistent
with reductions in various loans.
See "Net Interest Income and Interest Rate Risk" and "Other Operating Expense"
for a discussion of the effects of these events on recent or prospective
operating results.
As indicated in Table 13, time certificates of deposit of $100,000 or more from
money desk operations represented a less significant source of funding during
1995 than in 1994. In general, deposits of more than $100,000 are considered to
be more volatile than fully-insured deposits in denominations of less than
$100,000. At December 31, 1995, 18.2% of total time certificates of deposit of
$47.1 million were represented by accounts individually in excess of $100,000 as
compared to 16.1% of total time certificates of deposit of $76.0 million at
December 31, 1994. Time certificates of deposit from the money desk operation
comprised 29.2% of time certificates of deposit in excess of $100,000 in 1995 as
compared to 32.1% in 1994
While time certificates of deposit in the aggregate do not exhibit the daily
volatility that characterizes commercial customers' noninterest-bearing demand
deposits, the stability of time certificates of deposit is dependent, in
significant part, on such depositors' perceptions of the Bank's financial
strength. Management believes that the Bank's ability to compete for potential
customers' deposits during 1995 has been hampered to some extent by concerns
arising from the Company's reported net losses.
The Bank's customers are principally commercial in nature and are attracted
primarily on the basis of personal relationships and service quality. A portion
of those customers maintain deposit accounts having balances significantly in
excess of current federal deposit insurance limits. At December 31, 1995, 45.1%
of total deposits, excluding time certificates of deposit attributable to the
money desk, were held in accounts with balances of $100,000 or more.
Money Desk Deposits
The Bank's wholesale institutional funds acquisition operation ("money desk")
was established in September 1990. The money desk solicits time certificates of
deposit from institutional investors nationwide, including other banks, savings
and loans, credit unions, trust companies, and pension funds beyond the Bank's
traditional market area, comprised of the west side of the City of Los Angeles.
Although management believed that deposits gathered through the money desk are
less costly and provide greater capacity for overall deposit growth than
brokered deposits, the rates paid on certificates of deposits gathered through
this vehicle are higher than those offered in the local market. The Bank's focus
will be to attract deposits from its traditional local market area. However, the
Bank's policy is to activate the money desk operation as necessary, if the
Bank's liquidity falls below specified levels. Brokered deposits will not be
solicited through the money desk.
Other Liquidity Sources
Management continues to seek additional sources of liquidity. Additional sources
of liquidity available to the Bank are securities available-for-sale and federal
funds sold which may be immediately converted into cash at a minimal cost.
Management intends to use these additional sources of liquidity to the extent
necessary.
41
44
Pursuant to FDICIA, the use of brokered deposits is limited to institutions
categorized as "well-capitalized" and, upon the issuance of a waiver by the
FDIC, to "adequately capitalized" institutions. As a result of the Formal
Agreement, the Bank is presently considered only adequately capitalized under
the FDIC regulations. Although the Bank did not anticipate using brokered
deposits, it cannot avail itself of brokered deposits as a source of liquidity.
Repurchase Agreements
The Bank has borrowed funds from investment banking firms (dealers) and
customers pursuant to sales of securities under repurchase agreements. Those
repurchase agreements provide for the Bank's sale of investment securities to
dealers or customers with simultaneous agreement to repurchase identical
securities on specified dates and at specified prices. The initial price paid to
the Bank under such wholesale (dealer) and retail (customer) repurchase
agreements is less than the fair market value of the investment securities sold,
and the Bank may be required to pledge or deliver additional securities if the
fair market value of the investment securities sold declines below the price
initially paid to the Bank for those securities. Borrowings under repurchase
agreements are collateralized by U.S. Treasury or government agency securities
and mortgage pass-through certificates guaranteed or issued by the Government
National Mortgage Corporation, Federal National Mortgage Association, and
Federal Home Loan Mortgage Corporation.
The Bank's borrowings under repurchase agreements are summarized in Table 14.
Wholesale (dealer) repurchase agreements have not represented a significant
source of liquidity. However, there remain market and credit risks associated
with repurchase agreements. In the event of sudden short-term market interest
rates increases, the costs of this funding source could increase concurrent with
a decline in the fair value of the underlying investment securities. As a
result, the Bank would be required to deliver additional securities, thereby
reducing the amount of investment securities otherwise available for
collateralized borrowings.
Wholesale (dealer) repurchase agreements involve credit risk to the extent that
the fair value of underlying investment securities exceeds the amount advanced
to the Bank under the related repurchase agreement. Securities subject to such
repurchase agreements are held in the name of the Bank by the dealers who
arrange the transactions. In the event the dealer defaults and the Bank is
unable to obtain the collateralizing investment securities, the Bank's risk of
loss is the amount of any such excess fair market value. The Bank's wholesale
(dealer) repurchase agreements are primarily overnight transactions. As a
result, management believes that the credit risks associated with this funding
source are substantially limited.
42
45
Table 12
Funding Composition and Liquidity Trends
(Balances are period averages)
Three month period ended
------------------------------------------------------------------
Two months
ended
February 29, December 31, September 30, June 30, March 31,
1996 1995 1995 1995 1995
--------------- --------------- --------------- --------------- ---------------
(dollar amounts in thousands)
Noninterest-bearing demand deposits:
Real estate title and escrow company
customers $ 7,971 7% $ 9,057 7% $ 11,831 9% $ 10,756 8% $ 12,085 7%
All other noninterest-bearing demand 30,247 26% 34,629 28% 42,869 33% 42,801 30% 45,108 27%
Interest-bearing demand, money market
and savings 29,575 25% 29,832 24% 31,619 24% 36,999 26% 40,240 24%
Time certificates of deposit:
Money desk operation 32,901 28% 32,035 26% 23,793 18% 32,699 23% 46,696 28%
All other:
$100,000 or more 5,640 5% 5,793 5% 6,300 5% 6,530 5% 7,401 4%
Under $100,000 9,010 8% 8,857 7% 8,625 7% 7,457 5% 9,147 7%
-------- ----- -------- ----- -------- ----- -------- ----- -------- -----
Total time certificates of
deposit $ 47,551 41% $ 46,685 39% $ 38,718 30% $ 46,686 33% $ 63,244 39%
-------- ----- -------- ----- -------- ----- -------- ----- -------- -----
Total deposits 115,344 99% 120,203 98% 125,037 96% 137,242 97% 160,677 97%
Federal funds purchased -- -- -- -- -- -- -- -- -- --
Securities sold under agreements to
repurchase 1,508 1% 2,585 2% 4,914 4% 4,144 3% 5,011 3%
Other short-term borrowings -- -- -- -- -- -- -- -- -- --
-------- ----- -------- ----- -------- ----- -------- ----- -------- -----
Total funding liabilities $116,852 100% $122,788 100% $129,951 100% $141,386 100% $165,688 100%
======== ===== ======== ===== ======== ===== ======== ===== ======== =====
Average loan-to-deposit ratio 68.0% 70.7% 76.2% 71.5% 68.7%
======== ===== ======== ===== ======== ===== ======== ===== ======== =====
Average purchased funds ratio 0.0% 0.0% 0.0% 0.0% 0.0%
======== ===== ======== ===== ======== ===== ======== ===== ======== =====
Period-end pledged securities ratio 63.2% 88.1% 83.9% 66.7% 22.9%
======== ===== ======== ===== ======== ===== ======== ===== ======== =====
Year ended December 31,
-------------------------------------------------
1995 1994 1993
--------------- --------------- ---------------
(dollar amounts in thousands)
Noninterest-bearing demand deposits:
Real estate title and escrow company
customers $ 10,932 8% $ 18,949 8% $ 21,236 8%
All other noninterest-bearing demand 41,313 30% 58,496 26% 68,369 26%
Interest-bearing demand, money market
and savings 36,342 26% 49,345 22% 61,104 23%
Time certificates of deposit:
Money desk operation 33,806 24% 74,657 33% 87,599 33%
All other:
$100,000 or more 6,506 5% 6,141 3% 10,390 4%
Under $100,000 5,318 4% 5,167 3% 3,236 1%
-------- ----- -------- ----- -------- -----
Total time certificates of
deposit $ 45,630 33% $ 85,965 39% $101,225 38%
-------- ----- -------- ----- -------- -----
Total deposits 134,217 97% 212,755 95% 251,934 95%
Federal funds purchased -- -- 179 -- 107 --
Securities sold under agreements to
repurchase 4,154 3% 10,685 5% 13,922 5%
Other short-term borrowings -- -- -- -- -- --
-------- ----- -------- ----- -------- -----
Total funding liabilities $138,371 100% $223,619 100% $265,963 100%
======== ===== ======== ===== ======== =====
Average loan-to-deposit ratio 71.4% 65.8% 63.4%
======== ======== ========
Average purchased funds ratio 0.0% 0.1% 0.0%
======== ======== ========
Period-end pledged securities ratio 88.1% 94.9% 11.0%
======== ======== ========
43
46
Table 13
Maturities of Time Certificates of Deposit
$100,000 or more at December 31, 1995
Money All
Desk Other Total
------ ------ ------
(dollar amounts in
thousands)
Aggregate maturities of time certificates of deposit:
In three months or less $ 400 $4,196 $4,596
After three months but within six months 300 958 1,258
After six months but within twelve months 1,392 900 2,292
After twelve months 405 0 405
------ ------ ------
Total time certificates of deposit $100,000 or more $2,497 $6,054 $8,551
====== ====== ======
Table 14
Securities Sold under Agreements to Repurchase
1995 1994 1993
------ ------- -------
(dollar amounts in thousands)
Balance at December 31 $4,497 $12,572 $ 8,023
Weighted average interest rate at December 31 2.18% 2.47% 2.13%
Weighted average maturity at December 31 (days) 7 5 4
Average balance during the year ended December 31 $4,093 $10,685 $13,922
Weighted average interest rate during the year ended December 31 2.61% 2.96% 2.50%
Maximum balance outstanding at any month-end during the year ended
December 31 $7,031 $15,127 $40,805
REGULATORY AGREEMENTS
Formal Agreement (OCC)
As a result of a Report of Examination dated March 6, 1995, the OCC and the Bank
have entered into a formal agreement dated December 14, 1995 ("Formal
Agreement"), which supersedes and replaces in its entirety a Formal Agreement
entered into by the Bank on July 26, 1991. The Formal Agreement provides that
the Bank must (a) provide monthly progress reports to the OCC; (b) employ a
Chief Financial Officer after approval by the OCC; (c) not pay directors fees;
(d) review all management fees, consulting contracts and severance plans; (e)
analyze new products and services; (f) maintain sufficient liquidity; (g)
develop a three year capital plan; (h) develop a strategic plan; and (i)
implement a written loan administration program. A capital plan was submitted to
the OCC on February 8, 1996, and a loan administration program was submitted on
February 29, 1996. The strategic plan is due on April 30, 1996. The Bank has not
yet employed a chief financial officer.
The OCC is near completion of an examination of the Bank as of March, 1996.
Based on preliminary discussions with the OCC, management does not anticipate
any significant changes to its Formal Agreement.
At December 31, 1995, the Bank's capital leverage ratio was 4.67% and its Tier 1
capital to risk weighted assets ratio was 6.95%. Although the Bank did not meet
the minimum 6.5% and 10%, respectively required for these ratios by the Formal
Agreement, management believed at December 31, 1995, it was in compliance with a
substantial portion of the Formal Agreement and was making significant progress
toward achieving full compliance with the remaining requirements.
Failure to comply with the Formal Agreement can result in further regulatory
action such as a cease and desist order, the imposition of civil money penalties
against the Bank and its director and executive officers or the removal of one
or more directors or executive officers.
As required under and to comply with the reporting provisions of the Formal
Agreement, the Bank reports monthly on the status of its progress to the OCC.
The Bank has developed a detailed tracking system for determining and reporting
compliance with the Formal Agreement.
44
47
Memorandum of Understanding (FRBSF)
The FRBSF conducts inspections of the Company. The Company entered into a
Memorandum of Understanding ("1995 MOU") on October 26, 1995 with the FRBSF. The
1995 MOU supercedes and replaces a Memorandum of Understanding entered into by
the Company on October 25, 1991. The 1995 MOU prohibits the Company from paying
dividends without prior approval of the FRBSF and the OCC, requires the
submission of a plan to increase the Bank's capital ratios, requires the Company
to conduct a review of the senior and executive management of the Company and
the Bank, prohibits the incurrence or renewal of debt without the FRBSF's
approval, restricts cash expenditures in excess of $10,000 in any month and
prohibits the Company from making acquisitions or divestitures or engaging in
new lines of business without the FRBSF's approval. The Company may be subject
to further regulatory enforcement action by FRBSF.
45
48
ITEM 8. FINANCIAL STATEMENTS
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Independent Auditors' Report 47
Consolidated Balance Sheets 48
Consolidated Statements of Operations 49
Consolidated Statements of Changes in Shareholders' Equity 50
Consolidated Statements of Cash Flows 51
Notes to Consolidated Financial Statements 52
46
49
INDEPENDENT AUDITORS' REPORT
To the Board of Directors
National Mercantile Bancorp
Los Angeles, California
We have audited the accompanying consolidated balance sheets of National
Mercantile Bancorp and subsidiary (the "Company") as of December 31, 1995 and
1994 and the related consolidated statements of operations, changes in
shareholders' equity and cash flows for each of the years in the three year
period ended December 31, 1995. 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, such consolidated financial statements present fairly, in all
material respects, the financial position of National Mercantile Bancorp and
subsidiary as of December 31, 1995 and 1994 and the results of their operations
and their cash flows for each of the years in the three year period ended
December 31, 1995, in conformity with generally accepted accounting principles.
The accompanying 1995 consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed in Note
2 to the consolidated financial statements, the Company and its wholly owned
subsidiary, Mercantile National Bank (the "Bank"), are operating under
regulatory agreements with the Federal Reserve Bank of San Francisco and the
Office of the Comptroller of the Currency ("OCC"), respectively, that require
them to meet prescribed requirements. At December 31, 1995, the Bank did not
meet the leverage and tier-one risk-based capital requirements under its
agreement. If the Company or the Bank are unable to comply with the terms of the
agreements, one or more regulatory sanctions may result. These matters raise
substantial doubt about the Company's ability to continue as a going concern.
Management's plans concerning these matters and a description of the Bank's
capital plan which was submitted to the OCC are also described in Note 2. The
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.
DELOITTE & TOUCHE LLP
March 28, 1996
47
50
National Mercantile Bancorp and Subsidiary
CONSOLIDATED BALANCE SHEETS
December 31, 1995 and 1994
1995 1994
-------- --------
(dollars in thousands)
ASSETS
Cash and due from banks -- demand $ 9,272 $ 22,210
Federal funds sold and securities purchased under agreements to
resell 21,000 24,500
-------- --------
Cash and cash equivalents 30,272 46,710
Interest-bearing deposits with other financial institutions -- 195
Securities available-for-sale, at fair value; aggregate amortized
cost of $20,256 and $64,540 at December 31, 1995 and 1994,
respectively 20,102 61,483
FRB stock 315 573
Loans receivable held for sale, at fair value -- 6,599
Loans receivable 82,012 115,284
Allowance for credit losses (3,805) (3,063)
-------- --------
Net loans receivable 78,207 112,221
Premises and equipment, net 1,126 1,684
Other real estate owned 581 1,529
Income taxes receivable -- 77
Accrued interest receivable and other assets 1,389 1,908
-------- --------
$131,992 $232,979
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Deposits:
Noninterest-bearing demand $ 44,579 $ 87,430
Interest-bearing demand 7,737 13,844
Money market accounts 18,901 28,823
Savings 1,927 1,696
Time certificates of deposit:
$100,000 and over 8,551 12,261
Under $100,000 38,548 63,761
-------- --------
Total deposits 120,243 207,815
Securities sold under agreements to repurchase 4,497 12,572
Accrued interest payable and other liabilities 1,241 2,284
-------- --------
Total liabilities 125,981 222,671
Shareholders' equity:
Preferred stock, no par value; authorized 1,000,000 shares -- --
Common stock, no par value; authorized 10,000,000 shares; issued
and outstanding 3,078,146 at December 31, 1995 and 1994 24,614 24,614
Accumulated deficit (18,449) (11,249)
Net unrealized loss on securities available-for-sale (154) (3,057)
-------- --------
Total shareholders' equity 6,011 10,308
-------- --------
$131,992 $232,979
======== ========
See accompanying notes to consolidated financial statements.
48
51
National Mercantile Bancorp and Subsidiary
CONSOLIDATED STATEMENTS OF OPERATIONS
Years ended December 31, 1995, 1994 and 1993
1995 1994 1993
------- ------- -------
(dollars in thousands, except
per share data)
Interest income:
Loans, including fees $ 9,299 $16,149 $14,933
Securities held-to-maturity -- 610 4,696
Securities available-for-sale 1,395 3,675 359
Trading securities -- 130 217
Federal funds sold and securities purchased under agreements to
resell 933 333 375
Interest-bearing deposits with other financial institutions 7 3 32
------- ------- -------
Total interest income 11,634 20,900 20,612
Interest expense:
Interest-bearing demand 137 144 171
Money market and savings 1,002 1,274 1,301
Time certificates of deposit:
$100,000 and over 542 471 562
Under $100,000 2,188 3,309 3,534
------- ------- -------
Total interest expense on deposits 3,869 5,198 5,568
Federal funds purchased and securities sold under agreements to
repurchase 110 328 352
------- ------- -------
Total interest expense 3,979 5,526 5,920
------- ------- -------
Net interest income 7,655 15,374 14,692
Provision for credit losses 2,307 7,330 2,000
------- ------- -------
Net interest income after provision for credit losses 5,348 8,044 12,692
Other operating (losses) income:
Net (loss) gain on sale of trading securities -- (112) 43
Net loss on sale of securities held-to-maturity -- -- (13)
Net (loss) gain on sale of securities available-for-sale (1,233) (1,327) 113
Loss on termination of interest rate swap (1,294) -- --
Lower-of-cost-or-market adjustment on securities
available-for-sale -- -- (63)
International services 224 435 563
Investment services 254 283 241
Deposit-related and other customer services 737 696 795
Other income-shareholders' insurance claims 730 -- --
Loss on other real estate owned (733) (894) (205)
Loss on other assets -- (1,087) --
Lower-of-cost-or-market adjustment on loans held for sale -- (851) --
------- ------- -------
Total other operating (losses) income (1,315) (2,857) 1,474
Other operating expenses:
Salaries and related benefits 3,878 5,088 5,237
Severance costs 141 333 78
Net occupancy 1,468 1,832 1,968
Furniture and equipment 385 539 613
Printing and communications 270 420 505
Insurance and regulatory assessments 971 1,203 1,263
Customer services 853 837 631
Computer data processing 413 495 538
Legal services 749 768 1,171
Other professional services 1,546 1,406 1,094
Other real estate owned expenses 41 87 310
Promotion and other expenses 518 706 650
------- ------- -------
Total other operating expenses 11,233 13,714 14,058
------- ------- -------
(Loss) income before cumulative effect of change in accounting
principle (7,200) (8,527) 108
Cumulative effect of change in accounting for investments in debt
securities available-for-sale -- -- 63
------- ------- -------
Net (loss) income $(7,200) $(8,527) $ 171
======= ======= =======
(Loss) income per share before cumulative effect of
change in accounting principle $ (2.34) $ (2.79) $ 0.03
======= ======= =======
Net (loss) income per share $ (2.34) $ (2.79) $ 0.05
======= ======= =======
See accompanying notes to consolidated financial statements.
49
52
National Mercantile Bancorp and Subsidiary
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
Years ended December 31, 1995, 1994 and 1993
Net
Unrealized
Gain (Loss) on
Common Stock Securities
Preferred --------------------- Accumulated Available-
Stock Shares Amount Deficit for-Sale Total
------ --------- ------- ----------- -------------- -------
(dollars in thousands)
Balance at January 1, 1993 -- 3,035,379 $24,494 $ (2,893) $ -- $21,601
Stock options exercised 9,067 31 31
Net unrealized gain on
securities available-for-sale -- -- -- -- 396 396
Net income -- -- -- 171 -- 171
----- --------- ------- -------- ------- -------
Balance at December 31, 1993 -- 3,044,446 $24,525 $ (2,722) $ 396 $22,199
Stock options exercised -- 33,700 89 -- -- 89
Net unrealized loss on
securities available-for-sale -- -- -- -- (3,453) (3,453)
Net loss -- -- -- (8,527) -- (8,527)
----- --------- ------- -------- ------- -------
Balance at December 31, 1994 -- 3,078,146 $24,614 $ (11,249) $ (3,057) $10,308
Decrease in net unrealized loss
on securities available-for-
sale -- -- -- -- 2,903 2,903
Net loss -- -- -- (7,200) -- (7,200)
----- --------- ------- -------- ------- -------
Balance at December 31, 1995 -- 3,078,146 $24,614 $ (18,449) $ (154) $ 6,011
===== ========= ======= ========= ======== =======
See accompanying notes to consolidated financial statements.
50
53
National Mercantile Bancorp and Subsidiary
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31, 1995, 1994 and 1993
1995 1994 1993
-------- -------- --------
(dollars in thousands)
Net cash flows from operating activities:
Net (loss) income $ (7,200) $ (8,527) $ 171
Adjustments to reconcile net income (loss) to net cash
provided by
(used in) operating activities:
Accretion of sublease loss (458) (386) (295)
Depreciation and amortization 365 468 450
Provision for credit losses 2,307 7,330 2,000
Provision for OREO 733 411 --
Lower of cost or market adjustment on loans
held-for-sale -- 851 --
Loss on sale of securities held-to-maturity -- -- 13
Net loss (gain) on sale of securities available-for-sale 1,233 1,327 (113)
Net amortization of premiums on securities
held-to-maturity -- 19 319
Net amortization of premiums (accretion of discounts) on
securities held-for-sale 57 177 (28)
Net accretion of discounts on loans purchased (163) (4,196) (173)
Gains on termination of interest rate swap and cap
agreements accounted for as hedges of loans -- -- 2,004
Accretion of deferred gains, net amortization of
premiums on interest rate hedging contracts terminated -- (588) (1,690)
Loss on sale of other assets -- 1,087 --
Net loss on sale of OREO -- 483 205
Net decrease (increase) in trading securities -- 9,992 (3,923)
Decrease in accrued interest receivable and other assets 723 906 262
Decrease in accrued interest payable and other
liabilities (287) (409) (336)
-------- -------- --------
Net cash (used in) provided by operating activities (2,690) 8,945 (1,134)
Cash flows from investing activities:
Net decrease (increase) in interest-bearing deposits with
other
financial institutions 195 (96) 1,882
Purchase of securities held-to-maturity -- (11,964) (17,205)
Proceeds from sales of securities held to maturity -- -- 2,997
Proceeds from repayments and maturities of securities
held-to-maturity -- 8,000 20,277
Purchase of debt securities available-for-sale (8,013) (151,752) (7,989)
Proceeds from sales of securities available-for-sale 46,862 154,040 21,841
Proceeds from repayments and maturities of securities
available-for-sale 4,276 8,326 1,766
Proceeds from sale of loans 6,599 -- --
Purchase of loans -- -- (16,761)
Net decrease in loans 31,870 30,533 26,725
Proceeds from sale of OREO 215 4,637 1,761
Proceeds from sale of other assets -- 372 --
Net purchases of premises and equipment (105) (320) (248)
-------- -------- --------
Net cash provided by investing activities 81,899 41,776 35,046
Cash flows from financing activities:
Net decrease in demand deposits, money market and savings
accounts (58,649) (40,690) (43,029)
Net (decrease) increase in time certificates of deposit (28,923) (20,341) 3,639
Net (decrease) increase in funds payable on purchase of
securities
not yet settled -- (973) 973
Net (decrease) increase in securities sold under agreements
to repurchase and federal funds purchased (8,075) 4,549 (10,050)
Net proceeds from exercise of stock options -- 89 31
-------- -------- --------
Net cash used in financing activities (95,647) (57,366) (48,436)
-------- -------- --------
Net decrease in cash and cash equivalents (16,438) (6,645) (14,524)
Cash and cash equivalents, January 1 46,710 53,355 67,879
-------- -------- --------
Cash and cash equivalents, December 31 $ 30,272 $ 46,710 $ 53,355
======== ======== ========
See accompanying notes to consolidated financial statements.
51
54
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1995, 1994 and 1993
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Business and Basis of Presentation
The consolidated financial statements include the accounts of National
Mercantile Bancorp (the "Company") and its wholly owned subsidiary, Mercantile
National Bank (the "Bank"). All significant intercompany transactions and
balances have been eliminated. The Bank is the Company's only subsidiary. The
Bank operates as a commercial bank in the Los Angeles area. The accounting and
reporting policies of the Company and the Bank conform with generally accepted
accounting principles and general practice within the banking industry.
Cash and Cash Equivalents
For purposes of reporting cash flows, cash and cash equivalents include cash and
due from banks-demand, federal funds sold and securities purchased under
agreements to resell. Cash flows from interest rate swap agreements and collar
and floor contracts that are accounted for as hedges of loans and investments
available-for-sale are reflected in cash flows from operating activities, rather
than cash flows from investing activities.
Investments in Debt and Equity Securities
Investments in debt securities and equity securities with readily determinable
market values are classified into three categories based on the Company's intent
at acquisition date. The categories are: (1) held-to-maturity, (2)
available-for-sale and, (3) trading securities.
Debt securities available-for-sale are carried at estimated fair value.
Unrealized holding gains and losses are excluded from earnings and reported as a
net-of-tax amount in a separate component of shareholders' equity until
realized. Because the Bank has net operating loss carryforwards, no tax benefit
has been recorded from the unrealized loss.
Gains or losses on sales of securities are determined using the specific
identification method.
Securities transferred from one category to another are transferred at estimated
fair value.
Loans
Loans are reported at the principal amounts outstanding, net of (i) deferred net
loan origination fees, (ii) purchased discounts, (iii) deferred net gains on
sales or terminations of interest rate swap agreements and collar contracts
accounted for as hedges of loans, and (iv) the allowance for credit losses.
Nonaccrual loans are those for which management has discontinued accrual of
interest because (i) there exists reasonable doubt as to the full and timely
collection of either principal or interest or (ii) such loans have become
contractually past due ninety days with respect to principal or interest.
Interest accruals may be continued for loans that have become contractually past
due ninety days when such loans are well secured and in the process of
collection and, accordingly, management has determined such loans to be fully
collectible as to both principal and interest.
For this purpose, loans are considered well secured if they are collateralized
by property having a realizable value in excess of the amount of principal and
accrued interest outstanding or are guaranteed by a financially capable party.
Loans are considered to be in the process of collection if collection of the
loan is proceeding in due course either through legal action or through other
collection efforts which management reasonably expects to result in repayment of
the loan or its restoration to a current status in the near future.
When a loan is placed on nonaccrual status, all interest previously accrued but
uncollected is reversed against current period operating results. Income on such
loans is then recognized only to the extent that cash is received and where the
ultimate collection of the carrying amount of the loan is probable, after giving
consideration to borrowers' current financial condition, historical repayment
performance and other factors. Accrual of interest is resumed only when (i)
principal and interest are brought fully current and (ii) such loans are either
considered, in management's judgment, to be fully collectible or otherwise
become well secured and in the process of collection.
52
55
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
Troubled debt restructured loans are those for which the Company has, for
reasons related to borrowers' financial difficulties, granted concessions to
borrowers (including reductions of either interest or principal) that it would
not otherwise consider, whether or not such loans are secured or guaranteed by
others. Troubled debt restructurings occurring after January 1, 1995 are
included in impaired loans and accounted for as described below.
The Financial accounting Standards Board ("FASB") issued Statement of Accounting
Standards ("SFAS") SFAS No, 114 "Accounting by Creditors for Impairment of a
Loan" which was amended by SFAS No. 118, "Accounting by Creditors for Impairment
of a Loan -- Income Recognition and Disclosures", which eliminates the
provisions of SFAS No. 114 regarding how a creditor should report income on an
impaired loan and clarifies certain disclosure requirements. SFAS No. 114
prescribes the recognition criterion for loan impairment and the measurement
methods for certain impaired loans and loans whose terms are modified in
troubled debt restructurings. SFAS No. 114 states that a loan is impaired when
it is probable that a creditor will be unable to collect all principal and
interest amounts due according to the contracted terms of the loan agreement. A
creditor is required to measure impairment by discounting expected future cash
flows at the loan's effective interest rate, by reference to an observable
market price, or by determining the fair value of the collateral for a
collateral dependent asset.
SFAS No. 118 and No. 114 were adopted by the Bank in the first quarter of 1995,
and did not have a material effect on the consolidated financial condition or
results of operations.
Loan Origination and Credit-Related Fees
Nonrefundable fees and direct costs associated with the origination or purchase
of loans are deferred and netted against outstanding loan balances. Deferred net
fees and costs are recognized in interest income over the loan term using a
method which generally produces a level yield on the net investment in the loan.
Nonrefundable fees associated with the issuance of loan commitments are deferred
and recognized over the life of the loan as an adjustment of yield. Fees for
commitments which expire unexercised are recognized in other operating income
upon the expiration of the commitment. Fees received for standby letters of
credit written are recognized as other operating income over the term of the
related commitment.
Allowance for Loan Losses
The Company's allowance for loan losses is maintained at a level considered by
management to be adequate to absorb estimated losses inherent in the existing
portfolio, including commitments under commercial and standby letters of credit.
The allowance for credit losses is increased by the provision for credit losses
charged against operating results and decreased by the amount of net loan
charge-offs. Loan losses are fully or partially charged against the allowance
for credit losses when, in management's judgment, the full collectibility of a
loan's principal is in doubt.
In evaluating the adequacy of the allowance for credit losses, management
estimates the amount of the potential risk of loss for each loan that has been
identified as having below standard credit risk. Those estimates give
consideration to economic conditions and their effects on the borrower's
industry; borrower's financial data and management capabilities; and current
valuations of collateral where appropriate. An allowance for loan loss is
further allocated for all loans not so identified based upon the risk
characteristics of particular categories of loans and historical loss experience
in the portfolio, adjusted, as appropriate, for the estimated effects of current
economic conditions. Additional allowances are allocated on the basis of credit
risk concentrations in the portfolio and commitments and contingent obligations
under off-balance sheet commercial and standby letters of credit.
Other Real Estate Owned
Other real estate owned ("OREO") includes real property acquired in full or
partial satisfaction of loans through foreclosure, including direct foreclosure
or deed in lieu of foreclosure.
Foreclosed property is recognized at the property's estimated fair value less
estimated selling costs at the date of foreclosure, with any excess of the net
investment in the loan over the property's fair value less estimated selling
costs charged against the allowance for credit losses.
53
56
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
OREO is classified as held for sale and carried at the lower of estimated fair
value minus selling costs or cost. Subsequent write-downs of OREO resulting from
declining fair values are recorded in the periods in which they become known.
Costs of holding OREO are reflected in other operating expense as incurred.
Premises and Equipment, Net
Premises and equipment are presented at cost less accumulated amortization and
depreciation. Depreciation of furniture, fixtures and equipment is determined
using the straight-line method over the estimated useful lives of the related
assets. Leasehold improvements are amortized using the straight-line method over
the term of the related leases or the service lives of the improvements,
whichever is shorter.
Income Taxes
The Company and the Bank file consolidated federal and combined state income tax
returns on a calendar year basis.
Deferred tax assets and liabilities are recognized for the expected future tax
consequences of existing differences between financial reporting and tax
reporting bases of assets and liabilities, as well as for operating losses and
tax credit carryforwards using enacted tax laws and rates. Deferred tax expense
represents the net change in deferred tax asset or liability balance during the
year. This amount, together with income taxes currently payable or refundable in
the current year, represents the total tax expense for the year.
(Loss) Income Per Share
(Loss) Income per share is computed using the weighted average number of common
shares outstanding during the period. The weighted average number of common
shares outstanding for the years ended December 31, 1995, 1994 and 1993 were
3,078,146, 3,055,584, and 3,041,268, respectively. Loss per share computations
exclude common share equivalents since the effect would be to reduce the loss
per share amount. Common share equivalents include the number of shares issuable
upon the exercise of stock options less the number of shares that could have
been purchased with the proceeds from the exercise of the options based upon the
higher of the average price of common shares during the period or the price at
the balance sheet date.
Interest Rate Swap Agreements and Hedging Contracts
During 1994 and 1995, the Company entered into interest rate swap agreements as
a means of moderating the impact of changes in the prime interest rate on income
from loans and investment securities. The differential to be received (paid) in
interest rate swap agreements is recognized in interest income from loans or
investments over the life of the related agreements.
The Company does not use interest rate swaps for trading purposes. Interest rate
swap agreements used to hedge the available-for sale investment securities are
carried at fair value and the unrealized gain or loss is included with the
unrealized gain or loss on its investment securities available-for-sale as a
separate component of equity. Interest rate swaps used to hedge the loan
portfolio are carried off-balance sheet.
Fair Value of Financial Instruments
Estimated fair value amounts have been determined using available market
information and appropriate valuation methodologies. Considerable judgment is
required to interpret market data and to develop the estimates of fair value.
Accordingly, the estimates of fair values in the financial statements are not
necessarily indicative of the amounts the Company could realize in a current
market exchange. The use of different market assumptions and estimation
methodologies may have a material effect on the estimated fair value amounts.
Recent Accounting Pronouncements
In 1995, the Financial Accounting Standards Board ("FASB") issued SFAS No. 123,
"Accounting for Stock-Based Compensation," which is effective for fiscal years
beginning after December 15, 1995 and encourages companies to account for stock
compensation awards based on their fair value at the date the awards are
granted. This statement does not require the
54
57
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 1 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
application of the fair value method and allows the continuance of the current
accounting method, which requires accounting for stock compensation awards based
on their intrinsic value as of the grant date. The Company has chosen not to
adopt the fair value provisions of SFAS No. 123 and will continue accounting for
stock compensation awards at their intrinsic value at the date of grant.
Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosures of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Reclassifications
Certain items in the 1994 and 1993 financial statements have been reclassified
to conform to the 1995 presentation.
NOTE 2 -- REGULATORY MATTERS
Going Concern
The accompanying consolidated financial statements have been prepared on a
going-concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. As shown in the
financial statements, the Company incurred net losses of $7.2 million and $8.5
million during the years ended December 31, 1995 and 1994, respectively. At
December 31, 1995, the Bank was not in compliance with the minimum capital
requirements prescribed by the formal agreement that the Bank entered into with
the Office of the Comptroller of the Currency (OCC) in December, 1995. The
formal agreement and regulatory capital requirements are described below. If the
Bank is unable to meet the minimum capital requirements of the formal agreement,
one or more regulatory sanctions may result. Management's plans concerning these
matters and a description of the Bank's capital plan which was submitted to the
OCC on February 8, 1996, and includes plans to raise additional capital are
described below.
These factors, among others, may indicate that the Company will be unable to
continue as a going concern. The financial statements do not include the
adjustments, if any, that might have been required had the outcome of the
above-mentioned uncertainties been known, or any adjustments relating to the
recoverability of recorded asset amounts or the amount of liabilities that may
be necessary should the Company be unable to continue as a going concern. The
Company's continuation as a going concern is dependent on the Bank's ability to
comply with the terms of the formal agreement, maintain sufficient liquidity,
and ultimately, return to profitable operations.
Managements' Plans
Although the Bank incurred significant losses which have eroded capital,
managements' primary focus is to return the Bank to profitability. In the fourth
quarter of 1995, the Bank significantly reduced its operating expenses through a
renegotiation of its lease obligations with its landlord, through a reduction in
its work force and reductions in other operating expenses. The lease
restructuring and reductions in staff and other non-interest expense will save
the Bank approximately $2.5 million per year. Management's plans for 1996
are to improve the quality of assets, continue to reduce operating expenses,
implement a focused business strategy, and increase revenues through increased
volume of fee based services and increased loans currently offered by the
Bank. Management's attainment of these objectives is dependent on the
economic developments in its principal market area. A turnaround in the
southern California economy will negate the impact the recession has had on the
Bank's borrowers and stimulate growth to enable the Bank to sell more services.
Conversely, further declines in the southern California economy could continue
to negatively impact the Company's ability to attain those planned objectives.
In addition, the Company has neither adequate cash flow nor the financial
flexibility to enable it to act as a source of financial strength to the Bank.
In addition, the Company is pursuing options to raise additional capital which,
if raised, will enable the Company and the Bank to exceed all minimum capital
ratios. A capital plan was filed with the OCC, as required under the agreement,
on February 8, 1996.
55
58
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 2 -- REGULATORY MATTERS (CONTINUED)
Regulatory Agreements
The Bank's principal regulator is the OCC. At periodic intervals, the OCC
examines and evaluates the financial condition, operations, and policies and
procedures of nationally chartered banks, such as the Bank, as part of its
legally prescribed oversight responsibilities. Based on its examinations, the
OCC can direct a national bank to adjust its financial statements in accordance
with the examination's findings. In view of the increasingly uncertain
regulatory environment in which banks now operate, the extent, if any, to which
future OCC examinations may ultimately result in adjustments to the financial
statements cannot presently be determined.
The OCC and the Bank have entered into Formal Agreement dated December 14, 1995
("Formal Agreement"), which supersedes and replaces in its entirety a Formal
Agreement entered into by the Bank on July 26, 1991. The Formal Agreement
provides that the Bank must (a) achieve and maintain, (i) a capital leverage
ratio equal to at least 6.5% and (ii) a Tier 1 capital to risk weighted assets
ratio equal to at least 10.0%; (b) provide monthly progress reports to the OCC;
(c) employ a Chief Financial Officer after approval by the OCC; (d) not pay
directors fees; (e) review all management fees, consulting contracts and
severance plans; (f) analyze new products and services; (g) maintain sufficient
liquidity; (h) develop a three year capital plan; (i) develop a strategic plan;
and (j) implement a written loan administration program. As mentioned above, a
capital plan was submitted to the OCC on February 8, 1996, and a loan
administration program was submitted on February 29, 1996. The strategic plan is
due on April 30, 1996. The bank has an active search underway for a chief
financial officer.
As set forth below, the Bank's capital leverage ratio at December 31, 1995 was
4.67%, and the Bank's Tier 1 capital to risk weighted assets ratio was 6.95%,
both of which were not in compliance with the Formal Agreement. Although the
Bank did not meet the minimum 6.5% and 10%, respectively required for these
ratios by the Formal Agreement, management believed at December 31, 1995, it was
in compliance with a substantial portion of the Formal Agreement and was making
significant progress toward achieving full compliance with the remaining
requirements.
As required under and to comply with the reporting provisions of the Formal
Agreement, the Bank reports monthly on the status of its progress to the OCC.
The Bank has developed a detailed tracking system for determining and reporting
compliance with the Formal Agreement.
The Company entered into a Memorandum of Understanding ("1995 MOU") on October
26, 1995 with the Federal Reserve Bank of San Francisco ("FRBSF"). This MOU
replaces the Memorandum of Understanding entered into by the Company and the FRB
in 1991. The 1995 MOU prohibits the Company from paying dividends without prior
approval of the FRB, requires the submission of a plan to increase the Bank's
capital ratios, requires the Company to conduct a review of the senior and
executive management of the Company and the Bank prohibits the incurrence or
renewal of debt without the FRB's approval, restricts cash expenditures in
excess of $10,000 in any month and prohibits the Company from making
acquisitions or divestitures or engaging in new lines of business without the
FRB's approval.
The Formal Agreement will impair the ability of the Bank to declare and pay
dividends to the Company since the Bank currently intends to retain any earnings
to augment its capital. As dividends from the Bank are the principal source of
income to the Company, and because the payment of dividends by the Company is
subject to prior approval of the FRBSF, it is unlikely that the Company will
declare and pay dividends in the foreseeable future.
Absent sales of equity securities or subordinated debt by the Company, capital
will increase only through the retention of earnings.
Regulatory Capital Requirements
The Federal Reserve Board ("FRB") and the OCC have issued guidelines (the
"guidelines") regarding risk-based capital requirements. The guidelines provide
detailed definitions of regulatory capital and assign different weights to
various assets and credit equivalent amounts of off-balance sheet financial
instruments, depending upon the perceived degree of credit risk to which they
expose such entities. Each banking organization is required to maintain a
specified minimum ratio of capital to the total of such risk-adjusted assets and
off-balance sheet financial instruments.
56
59
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 2 -- REGULATORY MATTERS (CONTINUED)
The risk-based capital ratios of the Company and the Bank are calculated under
the guidelines by dividing their respective qualifying total capital by their
respective total risk-weighted assets. The Company's qualifying total capital
and total risk-weighted assets are determined on a fully consolidated basis.
Total qualifying capital is comprised of the sum of core capital elements ("Tier
1 capital") and supplementary capital elements ("Tier 2 capital"). At December
31, 1995 and 1994, Tier 1 capital of the Company and the Bank consisted of their
respective amounts of common shareholders equity. Tier 1 capital excludes any
net unrealized gains or losses resulting from the implementation of SFAS No.
115. Tier 2 capital includes the allowance for credit losses, subject to
limitations.
Under the guidelines, total risk-weighted assets of the Company and the Bank are
determined by assigning balance sheet assets and credit equivalent amounts of
off-balance sheet financial instruments (see Note 8) to one of four broad risk
categories having risk weights ranging from zero % to 100%. The aggregate
dollar amount of each category is multiplied by the risk weight associated with
that category and the resulting weighted values from each category are summed to
determine total risk-weighted assets.
Each bank holding company and national bank must maintain (i) a minimum ratio of
core capital ("Tier 1 Capital") to total risk-weighted assets of 4.0% and (ii) a
minimum ratio of total qualifying capital to total qualifying assets ("total
risk-based capital ratio") of 8.0%, with the amount of the allowance for credit
losses that may be included in supplementary capital ("Tier 2 Capital") limited
to 1.25% of total risk-weighted assets.
Capital leverage ratio standards require a minimum ratio of Tier 1 capital to
adjusted total assets ("capital leverage ratio") of 3%. The leverage ratio is
only a minimum. Institutions experiencing or anticipating significant growth or
those with other than minimum risk profiles will be expected to maintain capital
well above the minimum levels.
Shareholders' Equity and Regulatory Requirements
Information about the regulatory capital of the Company and the Bank at December
31, 1995 and 1994 is set forth below.
1995 1994
------------------------------------ -------------------------------------
Company Bank Company Bank
---------------- ----------------- ----------------- -----------------
Amount Ratio Amount Ratio Amount Ratio Amount Ratio
-------- ----- -------- ------ -------- ------ -------- ------
(dollar amounts in thousands)
Risk-based capital(3):
Tier 1 capital $ 6,166 6.96% $ 6,157 6.95% $ 13,365 9.84% $ 13,304 9.80%
Tier 1 capital minimum requirement 3,542 4.00% 8,856 10.00%(1) 5,431 4.00% 5,431 4.00%
-------- ----- -------- ------ -------- ------ -------- ------
Excess $ 2,624 2.96% $ (2,699) (3.05%) $ 7,934 5.84% $ 7,873 5.80%
======== ===== ======== ====== ======== ===== ======== ======
Total capital $ 7,306 8.25% $ 7,297 8.24% $ 15,079 11.11% $ 15,018 11.06%
Total capital minimum requirement 7,085 8.00% 7,085 8.00% 10,862 8.00% 13,578 10.00%
-------- ----- -------- ------ -------- ------ -------- ------
Excess $ 221 0.25% $ 212 0.24% $ 4,217 3.11% $ 1,440 1.06%
======== ===== ======== ====== ======== ===== ======== ======
Total risk-weighted assets $ 88,558 $ 88,558 $135,777 $135,777
Capital Leverage Ratio Standard(2)(3):
Tier 1 capital $ 6,166 4.68% $ 6,157 4.67% $ 13,365 5.65% $ 13,304 5.62%
Tier 1 capital minimum requirement(1) 5,271 4.00% 8,565 6.50%(1) 9,461 4.00% 15,374 6.50%
-------- ----- -------- ------ -------- ------ -------- ------
Excess (Deficiency) $ 895 0.68% $ (2,408) (1.83%) $ 3,904 1.65% $ (2,070) (0.88%)
======== ===== ======== ====== ======== ===== ======== ======
Average total assets, as adjusted, during
three-month periods ended December 31, $131,764 $131,764 $236,526 $236,526
- ---------------
(1) The Bank's minimum Tier 1 capital to risk weighted assets and Tier 1 capital
leverage requirements are based on the provisions of the Amended Formal
Agreement, which became effective on December 14, 1995.
(2) The regulatory capital leverage ratio represents the ratio of Tier 1 capital
at December 31, 1995 and December 31, 1994 to average total assets during
the three-month period then ended.
(3) Tier 1 capital excludes any unrealized gains or losses recorded under
Statement of Financial Accounting Standards No. 115.
57
60
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 3 -- AVERAGE FEDERAL RESERVE REQUIREMENTS
All depository institutions which are member banks are required to maintain
reserves on deposits representing transaction accounts in the form of balances
with the Federal Reserve Bank. The average reserve requirements for the Bank
were $1,462,000 and $4,209,000 for the years ended December 31, 1995 and 1994,
respectively. Neither the Company nor the Bank are required to maintain
compensating balances to assure credit availability under existing borrowing
arrangements.
NOTE 4 -- SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL
The Company enters into purchases of securities under agreements to resell
("reverse repurchase agreements") with primary dealers, as designated by the
Federal Reserve Bank of New York, only. Amounts advanced under these agreements
represent short-term invested cash included in cash and cash equivalents in the
balance sheet. Securities subject to reverse repurchase agreements are held in
the name of the Company by the dealers who arrange the transactions.
Overnight reverse repurchase agreements contain no provisions to ensure that the
fair value of the underlying securities remains sufficient to prevent loss to
the Company in the event of default by the counterparty. With respect to
agreements having terms in excess of one day, in the event that the fair value
of securities decreases below the carrying amount of the related reverse
repurchase agreements, the counterparties are required to designate an
equivalent amount of additional securities in the name of the Company.
Reverse repurchase agreements relating to mortgage-backed securities and U.S.
Treasury and government agency securities represent agreements to resell the
same securities.
There were no reverse repurchase agreements outstanding during 1995. During the
year ended December 31, 1994 the average balance of reverse repurchase
agreements was $2.0 million with a weighted average interest rate of 4.9%. The
maximum amount outstanding at any month-end during 1994 was $2.0 million.
NOTE 5 -- INVESTMENTS IN DEBT AND EQUITY SECURITIES
In December 1993, the Company implemented SFAS No. 115 "Accounting for Certain
Investments in Debt and Equity Securities" which resulted in the transfer of
$61.6 million from held-to-maturity to available-for-sale. In accordance with
the provisions of the statement, the lower of cost or market (LOCOM) adjustments
recorded during 1993 were reversed from current year net income and reported on
the income statement as the cumulative effect of a change in accounting
principle. The unrealized holding gains and losses on available-for-sale
securities are included as a separate component of shareholders' equity.
In 1994, investment securities with an amortized cost of $12.9 million and fair
value of $12.5 million were transferred from the held-to-maturity category to
the available for sale category for regulatory capital and liquidity purposes.
Due to the transfer of securities from the held-to-maturity category, the Bank
subsequently began to classify all securities as available for sale.
The Company regularly monitors its investment portfolio for any deterioration in
the issuer's creditworthiness expected to continue for a prolonged period of
time which may result in a permanent impairment of the security's value. In such
a circumstance, any permanent decline in value is charged against earnings.
At December 31, 1995, a portion of the Company's investment securities portfolio
was pledged (excluding the Federal Reserve Bank stock) as collateral for retail
(customer) repurchase agreements, FRB discount lines and other deposits.
Securities pledged for customer repurchase agreements, FRB discount lines, and
other deposits, totaled $7.5 million, $9.1 million and $1.3 million,
respectively (Also see Note 10 -- Securities Sold Under Agreements to
Repurchase).
58
61
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 5 -- INVESTMENTS IN DEBT AND EQUITY SECURITIES (CONTINUED)
The following is a summary of gains and losses on securities available-for-sale
and interest income on securities held-to-maturity and available for sale:
Year Ended December 31,
------------------------------
1995 1994 1993
------- ------- ------
(dollars in thousands)
Gains and Losses:
Securities available-for-sale:
Gross realized gains $ 67 $ 25 $ 161
Gross realized losses (1,300) (1,352) (48)
------- ------- ------
Net realized (loss) gain $(1,233) $(1,327) $ 113
======= ======= ======
Interest Income:
Securities held-to-maturity:
Tax-exempt $ -- $ -- $ 50
Taxable -- 610 4,646
------- ------- ------
$ -- $ 610 $4,696
======= ======= ======
Securities available-for-sale:
Tax-exempt $ 12 $ 50 $ 45
Taxable 1,383 3,625 314
------- ------- ------
$ 1,395 $ 3,675 $ 359
======= ======= ======
The amortized cost, gross unrealized gains, gross unrealized losses, and
estimated fair values of the Company's investment in debt and equity securities
available for sale at December 31, 1995 and 1994, are presented below.
1995 1994
----------------------------------------------- -----------------------------------------------
Total Gross Gross Estimated Total Gross Gross Estimated
Amortized unrealized unrealized fair Amortized unrealized unrealized fair
cost gains losses value cost gains losses value
--------- ---------- ---------- --------- --------- ---------- ---------- ---------
(Dollar amounts in thousands)
Debt Securities Available for
Sale:
U.S. Treasury securities $ 1,010 $ -- $ -- $ 1,010 $12,000 $ 4 $ 55 $11,949
GNMA-guaranteed mortgage pass-
through securities 119 1 -- 120 5,325 33 255 5,103
FHLMC-issued mortgage
pass-through certificates 6,001 11 41 5,971 7,362 -- 253 7,109
Other government sponsored
agency securities 9,683 -- 55 9,628 14,869 -- 906 13,963
CMO's and REMICS's issued by
U.S. Gov't Agencies: 3,443 -- 70 3,373 23,353 2 1,688 21,667
Privately issued -- -- -- -- 1,532 -- 59 1,473
General obligation municipal
securities -- -- -- -- 99 -- 15 84
Interest Rate Swap -- -- -- -- -- 135 -- 135
------- ---- ---- ------- ------- ---- ------ -------
$20,256 $ 12 $166 $20,102 $64,540 $174 $3,231 $61,483
======= ==== ==== ======= ======= ==== ====== =======
59
62
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 5 -- INVESTMENTS IN DEBT AND EQUITY SECURITIES (CONTINUED)
Presented below are the contractual maturities of the Company's investment in
debt and equity securities available for sale at December 31, 1995. Actual
maturities may differ from contractual maturities to the extent that borrowers
have the right to call or repay obligations with or without call or repayment
penalties.
Carrying amount of investment securities maturing:
---------------------------------------------------------
After one but After five but
Within one within five within ten After ten
year years years years
------------ ------------ ------------ ------------
Amount Yield Amount Yield Amount Yield Amount Yield Total Yield
----- ---- ----- ---- ----- ---- ----- ---- ------ ----
(dollar amounts in thousands)
Debt Securities Available-for-Sale:
U.S. Treasury securities $1,010 5.02 % $ -- -- $ -- -- $ -- -- $ 1,010 5.02 %
GNMA-guaranteed mortgage pass-through
securities -- -- 120 6.01 % -- -- -- -- 120 6.01 %
FHLMC-issued mortgage pass-through
certificates -- -- -- -- -- -- 5,971 6.24 % 5,971 6.24 %
Other government sponsored agency
securities 2,999 4.99 % 6,629 5.06 % -- -- -- -- 9,628 5.04 %
CMO's and REMIC's issued by U.S. Gov't
sponsored agencies -- -- -- -- -- -- 3,373 5.54 % 3,373 5.54 %
------ ------ ------ ------ -------
$4,009 5.00 % $6,749 5.08 % $ -- -- $9,344 5.99 % $20,102 5.49 %
====== ====== ====== ====== =======
NOTE 6 -- LOANS AND LOANS HELD-FOR-SALE
The following is a summary of the major categories of loans outstanding at
December 31, 1995 and 1994:
1995 1994
------- --------
(dollars in
thousands)
Real estate construction and land development $ 1,093 948
Commercial loans:
Secured by one-to-four family residential properties 10,462 18,398
Secured by multifamily residential properties 2,538 2,368
Secured by commercial real properties 33,556 32,061
Other, secured and unsecured 23,877 43,385
Home equity lines of credit 5,857 2,867
Consumer installment and unsecured loans to individuals 4,860 15,691
------- --------
82,243 115,718
Deferred net loan origination fees, purchased discount, and deferred gain on
termination of interest rate swap and cap agreements (231) (434)
------- --------
$82,012 $115,284
======= ========
Weighted average yield for loans at December 31 9.46% 9.23%
======= ========
Loans held-for-sale at December 31, 1994 totaled $6.6 million, net of a lower of
cost or market adjustment of $851,000. The loans held-for-sale included
criticized loans of approximately $4.8 million, nonaccrual loans of $2.7 million
and loans that were previously charged-off. The loans were sold in February
1995. The carrying value at December 31, 1994 was based on the actual sales
price.
60
63
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 6 -- LOANS AND LOANS HELD-FOR-SALE (CONTINUED)
The following is a summary of activity in the allowance for credit losses for
the years ended December 31, 1995, 1994 and 1993.
1995 1994 1993
------- -------- -------
(dollars in thousands)
Balance, beginning of year $ 3,063 $ 6,697 $ 6,009
Provisions for credit losses 2,307 7,330 2,000
Loans charged off (2,632) (14,217) (2,435)
Recoveries of loans previously charged off 1,067 3,253 1,123
------- -------- -------
Balance, end of year $ 3,805 $ 3,063 $ 6,697
======= ======== =======
In September 1993, the Bank purchased $20.8 million in performing loans from the
FDIC, acting as receiver for a bank in Los Angeles. The purchase price was $16.8
million, net of an allowance for credit losses established by the Bank at the
time of purchase. Subsequent to 1993, the allowance for credit losses
established at the time of purchase was reclassified as a purchase discount on
loans. The total net discount of $4.0 million, net of premiums of $300,000, is
being accreted into interest income over the term of the related loans. The
effect of these adjustments resulted in additional interest income of
approximately $3.9 million for the year ended December 31, 1994 for which the
Bank recorded additional provisions for credit losses.
At December 31, 1995, the Bank had classified $8.5 million of its loans as
impaired, as determined in accordance with SFAS No. 114. These loans include
$573,000 of loans on nonaccrual status, and the Bank has allocated $696,000 of
its general allowance for potential credit losses to such loans. The average
recorded investment in impaired loans during the year ended December 31, 1995
was approximately $9.9 million. Interest income of approximately $0.8 million
was recognized on impaired loans during the year ended December 31, 1995.
The allowance is an estimate involving both subjective and objective factors and
its measurement is inherently uncertain, pending the outcome of future events.
Management's determination of the adequacy of the allowance is based on an
evaluation of the loan portfolio, previous loan loss experience, current
economic conditions, volume, growth and composition of the portfolio, the value
of collateral and other relevant factors. The ongoing recession, which was more
prolonged and severe in southern California than elsewhere in the country,
continued to have an adverse impact on the credit risk profile and performance
of the Bank's loan portfolio in 1995. Deterioration of cash flows, profit
margins and declining real estate market values have negatively affected many
borrowers' operating cash flows and ability to service debt. Although management
believes the level of the allowance as of December 31, 1995 is adequate to
absorb losses inherent in the loan portfolio, additional deterioration in the
economy of the Bank's lending area could result in levels of loan losses that
could not be reasonably predicted at that date.
The following is a summary of nonperforming loans at December 31, 1995 and 1994,
respectively.
1995 1994
------ -------
(dollars in
thousands)
Nonaccrual loans $ 573 $ 3,426
Troubled debt restructurings 5,167 5,582
Loans contractually past due ninety or more days with respect to either
principal or interest and continuing to accrue interest 221 1,507
------ -------
$5,961 $10,515
====== =======
Interest foregone on nonperforming loans outstanding during the years ended
December 31, 1995, 1994 and 1993 is summarized below.
1995 1994 1993
---- ------ ------
(dollars in thousands)
Income contractually due $160 1,164 1,029
Income received prior to nonperforming status -- -- (262)
---- ------ ------
Interest foregone $160 $1,164 $ 767
==== ====== ======
61
64
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 6 -- LOANS AND LOANS HELD-FOR-SALE (CONTINUED)
Included in interest foregone in 1995, 1994 and 1993 is $5,000, $12,000 and
$189,000, respectively, of interest received that was applied as a reduction of
the principal balance of the related loan.
The ability of the Company's borrowers to honor their contracts is substantially
dependent upon economic conditions and real estate market values throughout the
Company's market area. At December 31, 1995, loans aggregating $53.5 million
were collateralized by liens on residential and commercial real properties.
While the Company's loan portfolio is generally diversified with regard to the
industries represented, at December 31, 1995, the Company's loans to businesses
and individuals engaged in entertainment industry-related activities amounted to
$9.4 million, including $1.2 million of such loans which are collateralized by
real property.
The Company has extended credit to certain directors and business enterprises in
which they have interests. Loans amounting to $114,000 at January 1, 1994 were
repaid during 1994. There were no such loans in 1995.
NOTE 7 -- PREMISES AND EQUIPMENT AND LEASE COMMITMENTS
The following is a summary of the major components of premises and equipment at
December 31, 1995 and 1994.
1995 1994
------ ------
(dollars in
thousands)
Leasehold improvements $1,680 $2,188
Furniture, fixtures and equipment 3,418 4,556
------ ------
5,098 6,744
Less accumulated amortization and depreciation 3,972 5,060
------ ------
$1,126 $1,684
====== ======
Rent, amortization and depreciation expense, and rental income for the years
ended December 31, 1995, 1994 and 1993 are summarized below.
1995 1994 1993
------ ------ ------
(dollars in thousands)
Rent expense $1,940 $2,155 $2,005
Sublease income (246) (293) (254)
Accretion of sublease loss (458) (386) (295)
------ ------ ------
Net rent expense 1,236 1,476 1,456
Amortization of leasehold improvements 135 107 82
Other occupancy expense 97 249 430
------ ------ ------
Total occupancy expense $1,468 $1,832 $1,968
====== ====== ======
Depreciation expense $ 220 $ 333 $ 368
Other furniture and equipment expense 165 206 245
------ ------ ------
Total furniture and equipment expense $ 385 $ 539 $ 613
====== ====== ======
The Bank has leased, under lease agreements, modified by a Lease Restructure
Agreement as of December 31, 1995, 23,883 square feet of office space in west
Los Angeles. The leases expire in October 2004. The leases are subject to annual
adjustments for increases in property taxes and operating costs. Under the
provisions of the Lease Restructure Agreement, the Bank assigned its interests
in its subleases to the landlord. In conjunction with the execution of the Lease
Restructure Agreement, the Company has issued the landlord a warrant to purchase
shares of the Company's stock together with registration rights with respect to
such shares.
62
65
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 7 -- PREMISES AND EQUIPMENT AND LEASE COMMITMENTS (CONTINUED)
Minimum annual rental commitments under these leases at December 31, 1995 are
summarized below.
(dollars in)
thousands)
Year ending December 31,
1996 $ 668
1997 668
1998 668
1999 668
2000 692
2001 and thereafter 3,110
------
$6,474
======
NOTE 8 -- OFF-BALANCE SHEET FINANCIAL INSTRUMENTS
The Company is a party to financial instruments with off-balance sheet risk in
the normal course of business to meet the financing needs of its customers and
to reduce the impact on the Company's operating results of fluctuations in
market or managed index interest rates. These financial instruments include
commitments to extend credit, conditional obligations under standby letters of
credit, and interest rate swap agreements and collar contracts.
These financial instruments involve, to varying degrees, elements of credit and
interest rate risk in excess of the amounts recognized in the balance sheet. The
contract or notional amounts of those instruments reflect the extent of the
Company's involvement in those financial instruments. With respect to
irrevocable commitments to extend credit and standby letters of credit, the
Company's exposure to credit loss in the event of nonperformance by customers is
represented by the contractual amount of those instruments, less the realizable
value of any collateral held. For interest rate swap and collar transactions,
notional amounts do not represent exposure to credit loss.
Commitments to extend credit are agreements to lend to a customer provided there
is no violation of any condition established in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. Many of these commitments are expected to expire
without being drawn upon. As such, the total commitment amounts do not
necessarily represent future cash requirements.
The Company uses the same credit underwriting policies in granting or accepting
such commitments or contingent obligations as it does for on-balance sheet
instruments, evaluating customers' creditworthiness individually. The amount of
collateral obtained, if deemed necessary by the Company upon extension of
credit, is based on management's credit evaluation of the counterparty. The
nature of collateral obtained varies and may include deposits held in financial
institutions; marketable securities; accounts receivable, inventory, and plant
and equipment; and residential or income-producing commercial real properties.
Standby letters of credit written are conditional commitments issued by the
Company to guarantee the financial performance of a customer to a third party.
Those guarantees are primarily issued to support private borrowing arrangements.
The credit risk involved in issuing letters of credit is essentially the same as
that involved in extending loan facilities to customers. When deemed necessary,
the Company holds appropriate collateral supporting those commitments.
Management does not anticipate any material losses as a result of these
transactions. Losses, if any, from standby letters of credit are charged against
the allowance for credit losses.
Undisbursed commitments under revocable and irrevocable loan facilities amounted
to $11.6 million and $21.8 million at December 31, 1995 and 1994, respectively.
Contingent obligations under standby letters of credit totaled $413,000 and
$695,000 at December 31, 1995 and 1994, respectively. At December 31, 1995,
$363,000 of standby letters of credit was collateralized by either cash or
property, substantially all standby letters of credit expire within one year and
one such obligation for $100,000 extends to the year 2001.
Interest rate swap transactions involve the exchange of fixed and floating rate
interest payment obligations without the exchange of the underlying notional
(principal) amounts. The Company minimizes the credit risk associated with
interest rate swap
63
66
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 8 -- OFF-BALANCE SHEET FINANCIAL INSTRUMENTS (CONTINUED)
agreements by performing normal credit reviews of and establishing transaction
limits with counterparties. While the notional amounts are often used to
indicate the extent of involvement with these transactions, the amounts
potentially subject to credit risk are much less.
In December 1994, the Bank entered into an interest rate swap contract. Under
the terms of the agreement the Bank received a floating U.S. LIBOR rate, initial
rate of 6.8%, and paid an 8.2% fixed rate. The payments were calculated on a $30
million notional amount based on a three year term to be paid semi-annually. The
swap was intended to hedge the market value fluctuations of a portion of the
available-for-sale securities portfolio, and was terminated early in the second
quarter of 1995. The Bank realized a loss of $1,265,000 on the early termination
of the swap, which is included in Loss on Sale of Debt Securities -- AFS.
In October 1993, the Bank entered into an interest rate swap contract. Under the
terms of the agreement, the Bank received 6.0% fixed and paid floating-rate
prime for 21 months on a $10 million notional amount. The swap expired in
August, 1995.
During 1994, the Company recognized $544,000 in interest income which
represented the accretion of a deferred gain resulting from the sale of a prime
rate based floor component of an interest rate collar contract that expired in
June 1994. The twenty-four month collar contract had a notional amount of $100
million and provided for the Company's payment of the daily average New York
bank prime interest rate above 10 percent (the cap rate) and the receipt of the
prime interest rate below 8.5 percent (the floor rate).
NOTE 9 -- LITIGATION
Because of the nature of their activities, the Company and the Bank are subject
to pending and threatened legal actions which arise out of the normal course of
business. In the opinion of management, based upon opinions of legal counsel,
the disposition of all suits will not have a material adverse effect on the
consolidated financial position or results of operations of the Company.
On or about October 7, 1992, an action was commenced by two shareholders,
Messrs. Berlin and Zlotnick, of National Mercantile Bancorp ("Company"), in the
United States District Court for the Eastern District of Pennsylvania against
the Company and the following former and current directors, officers, and/or
employees of the Company: Messrs. Ladd, Thornburg, Hughes, Tomich, Bell,
Guldeman, Smith, Brewer, Wolfen, Winner, Thomson, Hickey, Grahm, and Domyan and
Ms. Romero and Ms. Thornton. The plaintiffs contend that the claims are being
asserted (a) on a derivative basis on behalf of the Company and (b) on behalf of
a purported class of (i) purchasers of the Company's stock during the period
October 7, 1989 through July 12, 1994 and (ii) persons who owned shares of the
Company on the record dates and who were eligible to vote at the 1990, 1991 and
1992 Annual Meetings of Shareholders of the Company. In or about November 1993,
the action was transferred on consent of all parties, to the United States
District Court of California (the "Court").
The complaint purports to assert various violations of the Securities and
Exchange Act of 1934 and state common law claims for violation of the directors'
alleged duty of candor, common law negligent misrepresentation and breach of
fiduciary duty, and waste of corporate assets. The plaintiffs seek class
certification, declaratory and injunctive relief, consequential and punitive
damages in an unspecified amount and attorneys' fees.
In December 22, 1994, the parties to the action filed a stipulation of
settlement (the Stipulation) with the Court. According to the Stipulation, all
claims in the action are to be settled, discharged and dismissed with prejudice.
The monetary portion of the settlement is to be funded solely by the Company's
insurer for the relevant time period ( approximately $1.6 million is being held
in an escrow account)and none of the defendants is to be required to pay any
portion of the settlement. In addition the Company will be required to issue
warrants to the class to purchase shares of the common stock of the Company
equal to 5.0% of the fully diluted issued and outstanding shares of the common
stock of the Company as of July 12, 1994. The exercise price of the warrants
shall be $3.55 per warrant. The warrants shall be exercisable during a three
year period commencing June 2, 1996 and ending June 2, 1999. Pursuant to the
court's order, plantiffs' attorneys received 30% of the monetary portion of both
the derivative and class settlement amount and will receive 30% of the warrants.
Also, pursuant to the court's order, in the two year period after the approval
of the proposed settlement, the Company will be required to elect two new
members to its board of directors from a list supplied by the plaintiffs.
64
67
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 9 -- LITIGATION
In February 1995, counterclaims were filed against the Bank in an action
commenced by British & Commonwealth Merchant Bank ("BCMB"), as agent for itself
and the Bank, in England against Lloyd's Underwriters and Company Underwriters
(collectively, "Lloyds"). The Bank and BCMB claim that Lloyd's owes them a
further $120,659 of insurance proceeds relating to a claim filed by BCMB (for
itself and the Bank) for approximately $7.8 million under policies insuring
repayment of a loan from the Bank and BCMB to Performance Guarantees, Inc. for
production of a film entitled "Barr Sinister". In or about November 1991,
Lloyd's paid approximately $7.8 million in insurance proceeds, which Lloyd's now
seeks to recover a half each from the Bank and BCMB. In its counterclaim,
Lloyd's contends that the Leading Underwriter lacked authority to issue the
insurance policies and endorsements on behalf of all of the insurers under which
payment was made and secondly, that material misrepresentations were made to the
Leading Underwriter as to the likely budget for the film and that if the Leading
Underwriter had known the true position he would not have accepted the film
under the relevant policies. Lloyd's position, therefore, is that such payment
should be returned to Lloyd's.
The Bank believes it has meritorious defenses to these counterclaims and intends
to defend the counterclaims vigorously. The Bank also believes that, if it is
unsuccessful in the counterclaims, the Bank has claims against other parties for
recovery of any amounts it may have to repay to Lloyd's.
NOTE 10 -- SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
The Company enters into sales of securities under agreements to repurchase
("repurchase agreements"). Repurchase agreements are treated as financings with
the related investment securities and obligations to repurchase those securities
reported in the balance sheet as assets and liabilities, respectively.
As part of its money management services offered to customers, the Company
offers retail repurchase agreements secured by U.S. Treasury and government
agency securities for the short-term investment of funds. Those securities may
be obtained by the Company pursuant to reverse repurchase agreements (see Note
4). Securities subject to repurchase agreements are retained by the Company's
custodian under written agreements that recognize the customers' interests in
the securities.
For wholesale (dealer) repurchase agreements, investment securities subject to
such agreements are delivered to the dealers who arrange the transactions. The
dealers may have sold, loaned or otherwise disposed of such securities to other
parties in the normal course of operations and have agreed to resell to the
Company identical securities at the repurchase agreements' maturities. The
Company may be required to deliver additional securities if the fair value of
the investment securities sold declines below the price initially paid to the
Company for those securities.
Presented below is information about repurchase agreements at December 31, 1995
and 1994. At December 31, 1995 and 1994, no material amount of repurchase
agreements were outstanding with any individual dealer.
1995
----------------------------------
Underlying
securities Repurchase
---------- liability
Estimated -------------------
fair Interest
Maturity/Type of Asset value Amount rate
- -------------------------------------------------------------------- ---------- ------ --------
2 to 30 days:
FHLMC-issued mortgage pass-through certificates $4,544 $2,882 1.86%
Other government agency securities 2,999 1,615 2.74%
------ ------
$7,543 $4,497 2.18%
====== ======
65
68
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 10 -- SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE (CONTINUED)
1994
-------------------------------------
Underlying
securities Repurchase
---------- liability
Estimated ----------
fair Interest
Maturity/Type of Asset value Amount rate
- ---------------------------------------------------------------- ---------- ------- ----------
2 to 30 days:
U.S. Treasury securities $ 10,004 $ 4,660 3.01%
GNMA-guaranteed mortgage pass-through certificates 1,946 $ 1,825 3.16%
Collateralized mortgage obligations and real estate mortgage
investment/conduits issued by U.S. government sponsored
agencies 8,271 6,087 1.86%
------- -------
$ 20,221 $12,572 2.47%
======= =======
Years Ended December
31,
--------------------
1995 1994
------ -------
Weighted average interest rate at the end of the year 2.18% 2.47%
Maximum amount outstanding at any month-end during the year $7,031 $15,127
Average balance outstanding during the year $4,093 $10,685
Weighted average interest rate for the year 2.61% 2.96%
NOTE 11 -- INCOME TAXES
No income tax provision (benefit) was recorded at December 31, 1995, 1994 and
1993, due to the utilization of all available financial statement income tax
benefits in 1991.
A reconciliation of the amounts computed by applying the federal statutory rate
of 35% for 1995, 1994 and 1993 to the loss or income before tax benefits and the
effective tax rate follows:
1995 1994 1993
---------------- ---------------- --------------
(dollars in thousands)
Tax provision (benefit) at statutory
rate $(2,545) (35%) $(2,960) (35%) $ 60 35%
Increase (reduction) in taxes resulting
from:
Tax-exempt income on state and
municipal securities and loans (67) (1%) (527) (6%) (271) (158%)
Valuation reserve 2,302 31.7% 3,671 43% 200 117%
Other, net 310 4.3% (184) (2%) 11 6%
------- ---- ------- --- ----- ----
$ -- --% $ -- --% $ -- --%
======= ==== ======= === ===== ====
66
69
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 11 -- INCOME TAXES (CONTINUED)
The major components of the net deferred tax asset at December 31, 1995 and 1994
are as follows:
1995 1994
------- ------
(dollars in
thousands)
Deferred tax assets:
Net operating losses $ 8,514 $5,621
Loan loss reserves 1,014 1,526
Sublease loss 9 371
Accrued expenses 126 139
Alternative minimum tax credits 218 218
Unrealized loss on securities available-for-sale -- 1,293
Other 180 187
------- ------
Total deferred tax assets 10,061 9,355
======= ======
Deferred tax liabilities:
State taxes 583 574
Swap gains and losses -- 61
Loan Fees 2 --
------- ------
Total deferred tax liabilities 585 635
------- ------
Net deferred tax asset $ 9,476 $8,720
Valuation allowance (9,476) (8,720)
------- ------
Net deferred tax asset, net of valuation allowance $ -- $ --
======= ======
Management believes that the temporary differences resulting in the ending
deferred tax asset are expected to reverse within the next three to five years.
These temporary differences will generate deductions which will be available to
offset future taxable income in the period that these differences reverse. To
the extent that these reversing timing differences are in excess of taxable
income, they will generate additional operating loss carryforwards.
The Company has recognized losses for financial statement purposes which have
not yet been recognized on an income tax return. For financial statement
purposes at December 31, 1995, the Company had net operating loss carryforwards
of approximately $23.5 million. For tax purposes at December 31, 1995, the
Company had federal net operating loss carryforwards of $21.5 million, which
begin to expire in the year 2007. The Bank has prior and current years'
California net operating loss carryforwards of $10.4 million; of which $327,000
expire in the year 1997, $396,000 expire in 1998 and the remaining expiring
subsequently thereafter. Future losses will not result in income tax benefits to
the Company until it generates sufficient taxable income to exhaust the present
net operating loss carryforward. In addition, the Bank has AMT credit
carryforwards with amounts and expiration periods as follows: $19,000 -- expires
in 2002; $88,000 -- expires in 2003; and $111,000 -- expires in 2004.
The Bank is not currently involved in any Internal Revenue Service or Franchise
Tax Board audit, nor has the Bank been informed of any scheduled audits.
NOTE 12 -- BENEFIT PLANS
Stock Option Plans. The Company has three stock option plans established in
1983, 1990 and 1994, respectively (together, the "Plans"). The Plans offer
executives and other key employees an opportunity to purchase shares of the
Company's common stock. The Plans provide for both nonqualified and incentive
stock options and specify a maximum ten-year term for each option granted.
Options are granted at exercise prices not less than the fair market value of
the stock at the date of grant and are exercisable as determined by the Board of
Directors.
Stock appreciation rights entitling the holder to exercise an option by taking
any appreciation over the option exercise price in stock or, with the consent of
the Board of Directors Stock Option Committee, in cash, also may be granted
under the 1990
67
70
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 12 -- BENEFIT PLANS (CONTINUED)
plan. A stock associated option is exercisable, and is exercisable only for such
period as the Stock Option Committee may determine. As of December 31, 1995, no
stock appreciation rights had been granted under the 1990 plan.
At December 31, 1995, 170,300 option shares were vested and exercisable under
the Plans. The remaining shares under option become exercisable as follows:
1996 -- 62,500; 1997 -- 21,875; 1998 -- 21,875; and 1999 -- 14,375. Following is
a summary of changes in stock options under the Plans.
Option price
Number range per share
------- ---------------
Outstanding, January 1, 1993 377,871 $2.50 - $11.50
Canceled (50,760)
Exercised (9,067)
-------
Outstanding, December 31, 1993 318,044 $2.50 - $ 5.00
Granted 55,000
Canceled (65,123)
Exercised (33,700)
-------
Outstanding, December 31, 1994 274,221 $2.87 - $ 5.00
Granted 80,000
Canceled (53,296)
-------
Outstanding, December 31, 1995 390,925 $3.00 - $ 5.00
=======
On February 28, 1992 the Board of Directors granted an option to purchase 12,000
shares of the Company's common stock to a director of the Company at a price of
$2.87 per share. As of December 31, 1995 all 12,000 shares were vested and
exercisable.
On January 18, 1991 and June 26, 1992 the Board of Directors granted an option
to purchase 12,000 shares of the Company's common stock each to two directors at
$4.50 and $2.25, respectively. These options expired unexercised on March 28,
1995 and October 8, 1995, respectively.
Defined Contribution Retirement Plan. The Company maintained a Defined
Contribution Retirement Plan under section 401(k) of the Internal Revenue Code.
Employees are eligible to participate following six months of continuous
employment. Under the plan, employee contributions were partially matched by the
Company through August 31, 1995. The plan remains in force for employee
contributions only. Such matching becomes vested when the employee reaches three
years of service. Plan expense was $16,000, $33,000 and $32,000 in 1995, 1994
and 1993, respectively.
68
71
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 13 -- PARENT COMPANY INFORMATION
The following financial information presents the balance sheets of the Company
on a parent-only basis as of December 31, 1995 and 1994, and the related
statements of operations and cash flows for each of the years in the three-year
period ended December 31, 1995.
Balance Sheets
December 31,
---------------------
1995 1994
-------- --------
(dollars in
thousands)
ASSETS
Cash with the Bank $ 9 $ 62
Investment in the Bank 6,002 10,246
-------- --------
$ 6,011 $ 10,308
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities $ -- $ --
-------- --------
-- --
Shareholders' equity:
Common stock 24,614 24,614
Accumulated deficit (18,449) (11,249)
Net unrealized (loss) gain on securities available-for-sale (154) (3,057)
-------- --------
Total shareholders' equity 6,011 10,308
-------- --------
Total liabilities and shareholders' equity $ 6,011 $ 10,308
======== ========
Statements of Operations
Years ended December 31,
-------------------------------
1995 1994 1993
------- ------- -----
(dollars in thousands)
Interest income $ 2 $ 18 $ 16
Other income 730 -- --
------- ------- -----
Total operating income 732 18 16
Other operating expense 85 87 118
------- ------- -----
Income (loss) before equity in undistributed net (loss) income of
the Bank 647 (69) (102)
Equity in undistributed net (loss) income of the Bank (7,847) (8,458) 273
------- ------- -----
Net (loss) income $(7,200) $(8,527) $ 171
======= ======= =====
69
72
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 13 -- PARENT COMPANY INFORMATION (CONTINUED)
Statements of Cash Flows
Years ended December 31,
---------------------------------
1995 1994 1993
------- ------- -----
(dollars in thousands)
Cash flows from operating activities:
Net (loss) income $(7,200) $(8,527) $ 171
Adjustments to reconcile net (loss) income to net cash
provided by (used in) operating activities:
Equity in undistributed net loss of the Bank 7,847 8,458 (273)
Other, net -- 1 1
------- ------- -----
Net cash provided by (used in) operating
activities 647 (68) (101)
Cash flows from investing activities:
Investment in Bank (700) (500) --
------- ------- -----
Net cash used in investing activities (700) (500) --
Cash flows from financing activities:
Net proceeds from issuance of common stock -- 89 31
------- ------- -----
Net cash provided by financing activities -- 89 31
------- ------- -----
Net decrease in cash and cash equivalents (53) (479) (70)
Cash and cash equivalents, beginning of year 62 541 611
------- ------- -----
Cash and cash equivalents, end of year $ 9 $ 62 $ 541
======= ======= =====
NOTE 14 -- AVAILABILITY OF FUNDS FROM BANK
The Company is a legal entity separate and distinct from the Bank. At present,
substantially all of the Company's revenues come from interest earned on
deposits held in the Bank (see Note 13). Management believes the Company's cash
balance plus interest revenues, on a separate-entity basis, are adequate to
cover its modest level of operating expenses.
The prior approval of the OCC is required if the total of all dividends declared
by a national bank in any calendar year exceeds the Bank's net income for that
year combined with its retained net income for the preceding two years, less any
required transfers to surplus. As a result of these limitations and net losses
incurred by the Bank, the Bank could not have declared dividends to the Company
at December 31, 1995 without the prior approval of the OCC.
The OCC also has authority under the Financial Institutions Supervisory Act to
prohibit the Bank from engaging in activities that the OCC regards as unsafe or
unsound in conducting its business. It is possible that, depending upon the
financial condition of the Bank and other factors, the OCC could assert that the
payment of dividends or other payments is, under some circumstances, considered
to be an unsafe or unsound practice. Further, future cash dividends by the Bank
to the Company will depend upon management's assessment of the Bank's future
capital requirements (see Note 2).
In addition, federal law restricts the Bank's extension of credit to, or the
issuance of a guarantee or letter of credit on behalf of, the Company.
Investments in stock or other securities of the Company are similarly restricted
as is the taking of such securities as collateral for loans. Restrictions
prevent the Company from borrowing from the Bank unless the loans are secured by
designated amounts of marketable obligations. Further, secured loans to and
investments in the Company or its affiliates by the Bank are limited to 10% of
the Bank's capital stock and surplus (as defined by federal regulations) and are
limited, in the aggregate, to 20% of the Bank's contributed capital (as defined
by federal regulations).
70
73
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 15 -- SUPPLEMENTAL CASH FLOW INFORMATION
The following information supplements the statements of cash flows:
1995 1994 1993
------ ------- -------
(dollars in thousands)
Interest paid $4,294 $ 5,628 $ 5,980
Income tax refunds 77 35 511
Non-Cash Investing and Financing Transactions:
Real estate loans transferred to OREO -- 2,285 4,600
Loan transferred to other assets -- 1,459 --
Loans transferred to loans held-for-sale -- 7,450 --
Loans made in conjunction with the sale of OREO -- 1,400 2,072
Securities held-to-maturity transferred to
available-for-sale -- 15,605 --
Unrealized gain(loss) on securities available-for-sale 2,903 (3,453) 396
Debt securities transferred to
available-for-sale/Implementation of SFAS No. 115 -- -- 61,600
Other transfers -- -- 15,500
NOTE 16 -- SEVERANCE COSTS
In connection with the Company's restructuring of the Bank to reduce operating
expenses, employees were terminated resulting in severance costs of $141,000,
$333,000 and $78,000 for the years ended December 31, 1995, 1994 and 1993,
respectively. Included in the total 1994 cost was $132,000, related to the
employment agreement of a former senior officer of the Bank which was terminated
by mutual agreement.
NOTE 17 -- DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair values of financial instruments at December 31, 1995 and
1994, are presented below.
December 31, 1995
-------------------
Carrying Fair
Amount Value
------- -------
(In thousands)
Financial Assets:
Cash and cash equivalents $30,272 $30,272
Securities available-for-sale 20,102 20,102
Loans net allowance for credit losses 78,207 76,496
Financial Liabilities:
Demand deposits, money market and savings 73,144 73,144
Time certificates of deposit 47,099 46,965
Securities sold under agreement to repurchase 4,497 4,497
Off Balance Sheet Financial Instruments:
Commercial and standby letters of credit -- 413
71
74
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 17 -- DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
December 31, 1994
---------------------
Carrying Fair
Amount Value
-------- --------
(In thousands)
Financial Assets:
Cash and cash equivalents $ 46,710 46,710
Interest-bearing deposits 195 195
Securities available-for-sale 61,921 61,921
Loans held-for-sale 6,599 6,599
Loans, net of allowance for losses 112,221 109,941
Financial Liabilities:
Demand deposits, money market and savings 131,793 131,793
Time certificates of deposit 76,022 75,644
Securities sold under agreement to repurchase 12,572 12,572
Off Balance Sheet Financial Instruments:
Commercial and standby letters of credit -- 14
Interest rate swap contract -- 102
The estimated fair value amounts have been determined using pertinent
information available to management as of December 31, 1995 and 1994.
Considerable judgment is required to interpret this information and develop the
estimates of fair value. Although management is not aware of any factors which
would significantly affect the estimated fair value amounts, such amounts have
not been comprehensively revalued for purposes of these financial statements
since that date and, therefore, current estimates of fair value may differ
significantly from the amounts presented therein.
The following methods and assumptions were used to estimate the fair value of
each class of financial instruments for which it is practical to estimate that
value.
Cash, cash equivalents and interest-bearing deposits. For those short-term
investments, the carrying amount is a reasonable estimation of fair value,
except for securities purchased under agreements to resell, for which fair value
is based on quoted market prices.
Trading and debt securities. For securities held for trading purposes, debt
securities held-to-maturity and available-for-sale, fair values are based on
dealer quotes or quoted market prices, if available. If a quoted market price is
not available, fair value is estimated using quoted market prices for similar
securities.
Loans. Variable rate loans have carrying amounts that approximate fair value.
The fair value of fixed rate loans is estimated by discounting the future cash
flows using the current rates at which similar loans would be made to borrowers
with similar credit ratings and for the same remaining maturities. In computing
the estimated fair value for all loans, estimated future cash flows have been
reduced by specific and general reserves for loan losses.
It was not practicable to estimate the fair value of nonaccrual loans of
approximately $600,000 at December 31, 1995, and $700,000 of the $3.4 million
that was on nonaccrual at December 31, 1994, ($2.7 million were included as
loans held-for-sale), because it is not practicable to reasonably assess the
credit adjustment that would be applied in the marketplace for such loans.
Demand deposits and time certificates of deposit. The fair value of demand
deposits, money market accounts and savings deposits is the amount payable on
demand at the reporting date. The fair value of fixed-maturity certificates of
deposit is estimated using the rates currently offered for deposits of similar
maturities.
Securities sold under agreements to repurchase. The carrying value for this
short term debt is a reasonable approximation of its fair value.
Commercial and standby letters of credit. The fair value of standby and
commercial letters of credit is based on fees currently charged for similar
agreements.
72
75
National Mercantile Bancorp and Subsidiary
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
December 31, 1995, 1994 and 1993
NOTE 17 -- DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
Interest rate floor and swap contracts. The fair value of the interest rate swap
contract is the amount the Company would receive to terminate the agreement at
the reporting date, taking into account the current interest rates and the
creditworthiness of the counterparty.
NOTE 18 -- QUARTERLY FINANCIAL DATA (UNAUDITED)
Quarterly financial information for the years ended December 31, 1995 and 1994
is presented below.
Three months ended
---------------------------------------------------------
March 31, June 30, September 30, December 31,
1995 1995 1995 1995
--------- -------- ------------- ------------
(dollars in thousands)
Interest income $ 3,458 $ 3,064 $ 2,871 $ 2,241
Interest expense 1,190 988 857 944
------- ------- ------- -------
Net interest income 2,268 2,076 2,014 1,297
Provision for credit losses (146) (381) (1,720) (60)
Net (loss) gain on securities available-for-sale (1,156) (47) (6) (24)
Loss on termination of interest rate swap -- (1,294) -- --
Loss on other real estate owned -- (169) -- (564)
Other operating income 371 1,151 204 219
Other operating expense (3,037) (3,089) (3,013) (2,094)
------- ------- ------- -------
Net loss $(1,700) $ (1,753) $(2,521) $ (1,226)
======= ======== ======= ========
Net loss per share $ (0.55) $ (0.57) $ (0.82) $ (0.40)
======= ======== ======= ========
Three months ended
---------------------------------------------------------
March 31, June 30, September 30, December 31,
1994 1994 1994 1994
--------- -------- ------------- ------------
(dollars in thousands)
Interest income $ 5,758 $ 5,774 $ 5,358 $ 4,010
Interest expense 1,298 1,265 1,411 1,552
------- ------- ------- -------
Net interest income 4,460 4,509 3,947 2,458
Provision for credit losses (1,618) (1,567) (2,366) (1,779)
Gain (loss) on trading securities (84) (39) 11 --
Net loss on debt securities held for sale (31) (30) 8 (1,274)
Net gain (loss) on securities available-for-sale -- -- -- (851)
LOCOM adjustment on securities available-for-sale (43) (105) (244) (502)
Gain (loss) on sale of other real estate owned 446 467 268 233
Other operating income -- -- (1,087) --
Other operating expense (3,288) (3,322) (3,349) (3,755)
------- ------- ------- -------
Net loss $ (158) $ (87) $(2,812) $ (5,470)
======= ======== ======= ========
Net loss per share $ (0.05) $ (0.03) $ (0.92) $ (1.78)
======= ======== ======= ========
73
76
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
"None"
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The five directors listed below were elected by the shareholders of the Company
at the Company's 1995 Annual Meeting of Shareholders and their current term
expires at the 1996 Annual Meeting of Shareholders and when their successors are
elected and qualified. Each director of the Company is also a director of
Mercantile National Bank (the "Bank").
Company Bank
Position with the Company and the Bank Director Director
Directors Age and Principal Occupation Since Since
- -------------------- ---- ---------------------------------------------------- ------ ------
Alan Grahm 73 Director, Chairman of Associated Sales. 1983 1982
Director and Secretary, President and Chief
A. Thomas Hickey 55 Executive Officer of Tea Garden Products, Inc. 1991 1991
Chairman of the Board, President and Chief Executive
Howard P. Ladd 74 Officer of the Company. 1983 1982
Director, President and Chief Executive Officer of
Scott A. Montgomery 54 the Bank. 1995 1995
Robert E. Thomson 54 Vice Chair of the Board, Executive Consultant. 1983 1982
Biographical Information of Directors
The following sets forth certain biographical information, present occupation,
and business experience for at least the past five years of the directors.
ALAN GRAHM has served as Chairman of the Board of Associated Sales, an import
concern, for more than five years. He is also the owner of Bonny Doon Vineyards
since 1981.
A. THOMAS HICKEY has served as President and Chief Executive Officer of Tea
Garden Products, Inc., a manufacturer and distributor of consumer products, for
more than five years. He also serves as Secretary of the Company and the Bank
since August 1995.
HOWARD P. LADD serves as Chairman of the Board of the Company and the Bank and
as President and Chief Executive Officer of the Company since August 1995. He
was also Chairman of the Board of Concord Technology Development, an information
systems company from 1991 to 1995. Prior to forming Concord Technology
Development (formerly Concord Media Systems) in 1991, Mr. Ladd was Chairman of
Ladd Electronics since 1989.
SCOTT A. MONTGOMERY serves as President and Chief Executive Officer of the Bank
since November 1995. Prior thereto, from September 1990 to September 1994, he
was President and Chief Operating Officer of Cupertino National Bank, Cupertino,
California. Mr. Montgomery is also Vice Chairman of the Board of Tracy Federal
Bank, F.S.B., Tracy, California, since March 1995.
ROBERT E. THOMSON is an Executive Consultant to Sterling Forest Corporation, a
real estate development company, since August, 1994 and served as the Chair and
Chief Executive Officer of Sterling Forest Corporation from January 1989 to
August 1994. Mr. Thomson has served as a consultant to the Company and the Bank
from March through July 1995 and as Interim President and Chief Executive
Officer of the Bank from August through October 1995. He also serves as Vice
Chair of the Company and the Bank since June, 1991 and has served as interim
Chief Executive Officer of the Bank from June to October, 1991.
74
77
EXECUTIVE OFFICERS OF THE COMPANY
The following table sets forth the names, ages, positions and certain
information with respect to the current executive officers of the Company and
the Bank, determined as of March 25, 1996.
Name Age Positions with the Company and the Bank(1)
- -------------------- ---- -----------------------------------------------------
Executive Vice President and Chief Credit Officer of
James F. Gardunio 45 the Company and the Bank.
A. Thomas Hickey 55 Secretary of the Company and the Bank.
Howard P. Ladd 74 President and Chief Executive Officer of the Company.
President and Chief Executive Officer of the Bank,
Scott A. Montgomery 54 Director of the Company.
Robert E. Thomson 54 Vice Chair of the Company and the Bank.
- ---------------
(1) Executive Officers of the Company and the Bank are appointed annually by the
Company and Bank Board of Directors, respectively, following their
respective meetings of shareholders, and serve at the pleasure of their
respective Boards.
Business Experience
Information concerning the business experience of Messrs. Hickey, Ladd,
Montgomery and Thomson is provided under the section for directors.
JAMES F. GARDUNIO has served as Executive Vice President and Chief Credit
Officer of the Company and the Bank since August, 1994. Prior thereto, from 1989
to 1994, he was employed as Senior Credit Policy Officer at California Federal
Bank, Los Angeles.
Compliance With Section 16(a)
Pursuant to Section 16(a) of the Securities Exchange Act of 1934 and Securities
and Exchange Commission ("SEC") regulations, the Company's directors, certain
officers, and greater than 10 percent shareholders are required to file reports
of ownership and changes in ownership with the SEC and the National Association
of Securities Dealers and to furnish the Company with copies of all such reports
they file.
Based solely on its review of copies of such reports received or written
representations from certain reporting persons, the Company believes that during
1995 all filing requirements applicable to its directors, officers and 10
percent shareholders were satisfied.
75
78
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth compensation information with respect to the
Company's and the Bank's Chief Executive Officers, the Executive Vice President
and Chief Credit Officer and one additional executive officer of the Bank, whose
employment terminated during 1995, whose total annual salary and bonus exceeded
$100,000 (the "Named Executives"). Comparative data is also provided for the
previous two fiscal years, where applicable. No cash compensation was paid by
the Company to any Named Executive; however, each Named Executive of the Company
also serves as executive officer of the Bank and receives compensation from the
Bank for services rendered in their capacities as such.
SUMMARY COMPENSATION TABLE
Awards Long Term Compensation
Annual Compensation ---------------- ------------------------------
---------------------- Other Annual All Other
Name and Principal Position Year Salary ($) Bonus ($) Compensation ($) Options # Compensation ($)
- --------------------------- ---- ---------- --------- ---------------- --------- ----------------
Howard P. Ladd 1995(1) --0-- --0-- --0-- --0-- --0--
President and Chief 1994 N/A
Executive Officer of the 1993 N/A
Company
Scott A. Montgomery 1995(2) 31,667 31,667(3) --0-- --0--(4) 2,393(5)
President and Chief 1994 N/A
Executive Officer of 1993 N/A
Mercantile National Bank
James F. Gardunio 1995 158,221 16,440(7)
Executive Vice President 1994(6) 82,500 25,000 3,000
and Chief Credit Officer 1993 N/A N/A
Robert E. Thomson 1995(8) 45,500
Interim President and 1994 N/A
Chief Executive Officer of 1993 N/A
Mercantile National Bank
Donald D. Thornburg 1995(9) 220,890 13,120(10) 88,376(11)
President and Chief 1994 297,500 20,780
Executive Officer 1993 300,000 18,469
Paddy C. Steffey 1995(12) 78,217 25,174(13)
Senior Vice President and 1994 N/A
Director of Operations 1993(14) N/A
- ---------------
(1) Mr. Ladd serves as President and Chief Executive Officer of the Company
since August 28, 1995. Mr. Ladd receives no compensation for his services.
(2) Mr. Montgomery commenced employment with the Bank on November 1, 1995 at an
annual salary of $190,000.
(3) Sign-on bonus.
(4) According to the terms of his employment, Mr. Montgomery will be granted an
option to purchase 200,000 shares of the Common Stock of the Company. (See
"Employment Agreements")
(5) Includes $2,393 health club membership dues.
(6) Mr. Gardunio commenced employment with the Company and the Bank on August
26, 1994 at an annual salary of $150,000.
(7) Includes $7,200 automobile allowance and $9,240 for Company matching 401(k)
contribution.
(8) Mr. Thomson served as Interim President and Chief Executive Officer of the
Bank from August 3, 1995 to October 31, 1995 on a consulting basis. Mr.
Thomson was also engaged by the Company and the Bank as a consultant from
April through July 1995 at a consulting fee of $12,500 per month.
(9) Mr. Thornburg's employment with the Company and the Bank terminated on
August 31, 1995.
(10) Deferred compensation pursuant to Mr. Thornburg's employment agreement.
(See "Employment Agreements")
(11) Includes $67,500 severance pay pursuant to Mr. Thornburg's employment
agreement, $6,000 automobile allowance, $5,636 club membership dues and
personal benefit in club membership allocated to Mr. Thornburg and $9,240
for Company matching 401(k) contribution.
(12) Mrs. Steffey's (formerly Leitelt) employment with the Bank terminated on
August 31, 1995.
(13) Includes $25,174 severance pay.
(14) Mrs. Steffey commenced employment with the Bank in July 1993 and received
annual compensation during 1993 and 1994 below the $100,000 threshold.
76
79
Employment Agreements
Mr. Thornburg, whose employment terminated on August 31, 1995, was employed
pursuant to a written employment agreement during 1995.
Mr. Thornburg's employment agreement ("Agreement"), effective as of December 1,
1991, expired on December 1, 1994. Pursuant to that Agreement, Mr. Thornburg was
entitled to receive payment of $300,000 annual base salary, payable semi-
monthly. The Agreement provided for deferred compensation of $20,000 per year
accruing as of the end of each full year of employment and which vests at 20%
per year beginning on the fourth anniversary of Mr. Thornburg's employment and
is fully vested on his eighth anniversary; accrual of deferred compensation
commenced in 1993. The vested portion is payable on the earlier of termination
of employment or the attainment of age 65. Mr. Thornburg was granted a
non-qualified option to purchase 200,000 shares of the Company's Common Stock
which vests 20% per year beginning on the first anniversary of his date of hire.
However, in the event of a Change in Control in the Company or the Bank and Mr.
Thornburg is terminated without cause within one year of the occurrence of a
Change in Control, then the unvested portion of his option shall immediately
vest. Among other things, pursuant to his Agreement, Mr. Thornburg is entitled
to vacation leave, the right to participate in any pension or other retirement
program available to the Bank's executive officers, club membership, a
relocation allowance, an auto allowance and severance pay. In the event that Mr.
Thornburg's employment is terminated prior to December 1, 1994 for reasons other
than disability or cause, he would have been entitled to receive annual base
salary through December 1, 1994; provided, that if his employment would have
terminated at any time after June 1, 1994 and prior to December 1, 1994, or if
his employment would have terminated because his Agreement was neither extended
nor renewed, Mr. Thornburg would have been entitled to receive a payment equal
to one-half of his then annual base salary. If Mr. Thornburg would have been
terminated for reasons of death or disability, he would have been entitled to
receive his base salary through the end of the month in which his employment was
terminated, such amount payable within 30 days of termination. If Mr. Thornburg
would have been terminated for cause, he would have received his base salary
through the date of termination.
Pursuant to an Extension and Addendum to Employment Agreement entered into as of
December 1, 1994 by and among the Company, the Bank and Mr. Thornburg (the
"Addendum"), the term of Mr. Thornburg's employment was extended for an
additional nine months, to and including August 31, 1995 (the "Term"). The
Addendum amended Mr. Thornburg's Agreement in the following respects: (a) Annual
base salary of $285,000; (b) in the event Mr. Thornburg's employment is
terminated for any reason other than permanent disability or cause, Mr.
Thornburg shall be entitled to receive a lump sum payment equal to his then
current base salary from the date of such termination to August 31, 1995; and,
in addition, he shall receive a lump sum severance payment equal to three months
base salary at the then annual rate; (c) in the event of Mr. Thornburg's
termination of employment because of the expiration of the Term, he shall be
entitled to receive payment on the last day of the Term equal to three months of
the base salary at the then annual rate; (d) the initial vesting date of Mr.
Thornburg's deferred compensation is amended to be the third anniversary of his
date of employment; and (e) the period within which Mr. Thornburg may exercise
his stock option grant is extended to six months. All other terms and conditions
of the Agreement remained in full force and effect.
Mr. Montgomery commenced employment as President and Chief Executive Officer of
Mercantile National Bank on November 1, 1995 pursuant to terms and conditions
outlined in a document dated November 1, 1995, entitled "CEO Term Sheet." The
CEO Term Sheet provides for the following terms of employment: Mr. Montgomery's
employment shall be for a three year term at an annual base salary of $190,000
for the first year, $210,000 for the second year and $230,000 for the third
year. Mr. Montgomery will also be entitled to incentive compensation of 5% of
pre tax net profit. In 1996 incentive compensation may be based on other factors
as determined by the Board of Directors. He is also entitled to 2% of net pretax
profit, provided that a minimum return ratio of 1.5% of pretax profit to assets
is achieved. This compensation may be paid in the form of a deferred annuity or
other suitable insurance as determined by the Board of Directors.
Mr. Montgomery also received a sign-on bonus equal to two months salary. The CEO
Term Sheet also provides for the grant of an option to purchase 200,000 shares
of the Company's Common Stock, 100,000 shares of which will vest as of November
1, 1995, 50,000 shares on November 1, 1996 and 50,000 shares on November 1,
1997. These options will provide for an anti-dilutive protection at 6.5% in the
event of issuance of new shares during the term of the contract and will become
fully vested in the event of a change of control of the Company.
Mr. Montgomery was also provided with a Bank owned automobile and membership in
an athletic club, as well as transitional living expenses and travel allowance
for a maximum of six months. The CEO Term Sheet further provides for a
relocation allowance of up to $35,000 and severance pay of 18 months base salary
plus any earned but unpaid bonus in the event of termination without cause or by
change of control with all normal benefits continuing during this period.
77
80
Compensation of Directors
As of October 1, 1995 the directors of the Company and the Bank receive no
compensation for their services as directors or members of any committee on
which they serve.
From January through April 1995 directors of the Company received a monthly fee
in the amount of $1,250 for the Chairman of the Board and $1,000 for other
directors. The directors did not receive compensation for Company Committee
meetings attended. Each director of the Company, however, also served as a
director of the Bank. Directors of the Bank, who are not employees, were
compensated as follows: The Chairman received $600 and other directors were paid
$450 for each Board meeting attended. For each Committee meeting attended, the
Chairman received $350 and the other directors were paid $250. For special or ad
hoc committee meetings of the Board of Directors, the Chairman and each director
received $250 per meeting attended.
As of May 1, 1995 the monthly retainer was reduced to $750 for all directors.
The Chairman received $600 and the other directors were paid $400 for each Bank
Board meeting attended and for each Committee meeting attended, the Chairman was
paid $250 and the other directors $200. Fees for attendance of special or ad hoc
committee meetings of the Board of Directors was reduced to $200 for each
director.
Compensation Committee Interlocks and Insider Participation
During various periods in 1995 Messrs. Grahm, Hickey, Ladd, Montgomery, Peevey,
Thomson and Thornburg served as members of the Nominating and Compensation
Committee. Except for Messrs. Thornburg, who served as President and Chief
Executive Officer of the Company and the Bank, and Mr. Montgomery who serves as
President and Chief Executive Officer of the Bank, the members of the Nominating
and Compensation Committee are or were outside directors. Mr. Thornburg was and
Mr. Montgomery is excluded from participation in the Nominating and Compensation
Committee or the full Board of Directors in any matter relating to their own
compensation.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The Board of Directors knows of no person who owns beneficially more than 5% of
the outstanding Common Stock of the Company as of March 25, 1996, other than the
following:
Number of
Name of Beneficial Owner Shares Percent
----------------------------------------------------- ----------- -----
9830 Investments No. 1, Ltd. 287,615 9.34%
9830 Wilshire Boulevard
Beverly Hills, California 90212
a California limited partnership
Thomson Horstmann & Bryant, Inc. 199,200 6.47%
Park 80 West/Plaza Two
Saddle Brook, New Jersey 07663
a New York corporation
78
81
The following table provides certain information with respect to the beneficial
ownership of shares by each Named Executive(1) and by each Company director and
nominee and by all of the directors and executive officers of the Company as a
group on March 25, 1996. For purposes of this table, the term "executive
officer" means the President and Chief Executive Officer of the Company, the
President and Chief Executive Officer of Mercantile National Bank (the "Bank"),
and the Executive Vice President and Chief Credit Officer of the Company and the
Bank.
Amount and
Nature of
Title of Beneficial Percent of
Class Name of Beneficial Owner Ownership(2) Class(3)
- ------------- ---------------------------------------- --------------- ------------
Common Stock Alan Grahm 80,993 2.66
Common Stock A. Thomas Hickey 13,000(4) *
Common Stock Howard P. Ladd 57,827 1.88
Common Stock Scott A. Montgomery 5,000 *
Common Stock Robert E. Thomson 625 *
Common Stock James F. Gardunio 6,250(5) 2.72
Common Stock All Current Directors and Executive 163,695(6) 5.32
Officers as a Group (6 persons)
- ---------------
* Less than one percent (1%)
(1) SEE "Executive Compensation."
(2) Directors and executive officers have sole voting and investment powers of
the shares, unless otherwise indicated below.
(3) The percentage is calculated based upon the total number of shares
outstanding on March 20, 1996 plus those shares each individual, or all
individuals as a group, has the right to acquire within 60 days of March 20,
1996.
(4) Includes 12,000 shares which Mr. Hickey has the right to acquire pursuant to
stock options exercisable within 60 days of March 20, 1996.
(5) Includes 6,250 shares which Mr. Gardunio has the right to acquire pursuant
to stock options exercisable within 60 days of March 20, 1996.
(6) Includes 18,250 shares which the directors and executive officers of the
Company have the right to acquire pursuant to stock options exercisable
within 60 days of March 20, 1996.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The Company and the Bank have made loans to certain directors from time to time.
All such loans have been made in the ordinary course of business and on
substantially the same terms, including interest rates and collateral, as those
prevailing at the time for comparable transactions with other persons. These
loans do not involve more than the normal risk of collectability or present
other unfavorable features. At December 31, 1995, there were no outstanding
loans to or guaranteed by any of the directors.
CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE
SECURITIES LITIGATION REFORM ACT OF 1995
The Company has decided to take advantage of the new "Safe Harbor" provisions of
the Private Securities Litigation Reform Act of 1995 (the "Reform Act"). In that
connection, this annual report on Form 10-K includes forward looking statements
concerning the Company. The forward looking statements are made pursuant to the
Reform Act. There are many factors that could cause the events in such forward
looking statements to not occur, including general or specific economic
conditions, the ability and willingness of customers to utilize the services
provided by the Bank, the perceived absolute or relative overall value of these
services by the Bank's customers, including the features, quality and price in
comparison to other competitive services, the amount and rate of growth and the
Company's selling, general and administrative expenses, the making or incurring
of any expenditures, the effects of and changes in monetary and fiscal policies,
laws and regulations, other activities of the government and its agencies and
similar organizations and social and economic conditions, such as inflation and
interest rate fluctuations or taxes, the costs and other effects of legal and
administrative cases and proceedings (whether civil or criminal), settlements
and investigations, claims and changes in those items, developments or
assertions by or against the Company or the Bank, adaptions of new, or changes
in, accounting policies and practices in the applications of such policies and
practices and the effects of changes within the Company's or the Bank's
organization or in compensation benefit plans, any activities of parties with
which
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the Company or the Bank has an agreement or understanding and the ability of the
Company to raise any additional capital on behalf of itself and the Bank.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following documents have been have been filed as a part of this report:
1. Financial Statements
Page
Independent Auditors' Report 47
Consolidated Balance Sheets at December 1995 and 1994 48
Consolidated Statements of Operations for the years ended December 31, 1995, 1994 and
1993 49
Consolidated Statements of Changes in Shareholders' Equity for the years ended December
31, 1995, 1994 and 1993 50
Consolidated Statements of Cash Flows for the years ended December 31, 1995, 1994 and
1993 51
Notes to Consolidated Financial Statements for the three years ended December 31, 1995 52
2. Financial Statement Schedules
None.
(b) Reports on Form 8-K
None
(c) Exhibits
See Index to Exhibits at pages 82 and 83 of this Report on Form 10-K
(d) See Item 14(a) above.
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83
SIGNATURES
Pursuant to the requirements of Section 13 or 15 (d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
NATIONAL MERCANTILE BANCORP
-----------------------------------------
(Registrant)
/s/ Howard P. Ladd
-----------------------------------------
Howard P. Ladd
Chief Executive Officer
/s/ Howard P. Ladd
-----------------------------------------
Howard P. Ladd
Acting Chief Financial Officer
Date: April 15, 1996
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
Signature Title Date
- ----------------------------------------------- ----------------------------------- ---------------
/s/ Howard P. Ladd Chairman of the Board and President April 15, 1996
- -------------------------- and Chief Executive Officer
Howard P. Ladd
/s/ Robert E. Thomson Vice Chair April 15, 1996
- --------------------------
Robert E. Thomson
/s/ Alan Grahm Director April 15, 1996
- --------------------------
Alan Grahm
/s/ A. Thomas Hickey Director and Secretary April 15, 1996
- --------------------------
A. Thomas Hickey
/s/ Scott A. Montgomery Director April 15, 1996
- --------------------------
Scott A. Montgomery
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84
INDEX TO EXHIBITS
Exhibit
No.
- ------
3.1 Articles of Incorporation dated January 17, 1983, as amended by Certificate of Amendment of
Articles of Incorporation dated May 8, 1984, and as amended by Certificate of Amendment of Articles
of Incorporation dated March 7, 1989(1)
3.2 Bylaws of the Company, as amended, restated as of December 18, 1992(3)
10.1 Memorandum of Understanding dated October 25, 1991 between the Federal Reserve Bank of San
Francisco and the Company(2)
10.2 Memorandum of Understanding dated October 26, 1995 between the Federal Reserve Bank of San
Francisco and the Company.
10.3 Formal Agreement dated July 26, 1991 between the Office of the Comptroller of the Currency and
Mercantile National Bank(2)
10.4 Amendment to the Agreement by and between Mercantile National Bank and the Office of the
Comptroller of the Currency dated December 14, 1995.
10.5 Restated Employment Agreement as of December 1, 1991, between Mercantile National Bank and Donald
D. Thornburg(2)
10.6 Extension and Addendum to Employment Agreement as of December 1, 1994 between Mercantile National
Bank and Donald D. Thornburg(5)
10.7 Letter agreement dated July 11, 1994, between Mercantile National Bank and James F. Gardunio(5)
10.8 Consulting Agreement dated November 9, 1994, between National Mercantile Bancorp and Don M.
Griffith(5)
10.9 Letter Agreement dated May 28, 1993 between Mercantile National Bank and Paddy C. Leitelt(4)
10.10 CEO Term Sheet dated November 1, 1995 between Mercantile National Bank and Scott A. Montgomery.
10.11 Financial Institution Services Agreement dated April 8, 1993 between Mercantile National Bank and
Linsco/Private Ledger(4)
10.12 Form of Indemnity Agreement between the Company and its directors(1)
10.13 Form of Indemnity Agreement between the Company and its executive officers(1)
10.14 First Floor Lease at 1840 Century Park East, Los Angeles, California, dated as of December 21, 1982
between Northrop Corporation and Mercantile National Bank(3)
10.15 Second Floor Lease at 1840 Century Park East, Los Angeles, California, dated as of December 21,
1982 between Northrop Corporation and Mercantile National Bank for space at 1840 Century Park East,
Los Angeles, California, as amended by Amendment to Second Floor Lease dated as of June 7, 1986,
and as amended by Second Amendment to Second Floor Lease dated as of December 18, 1992 between
California State Teachers' Retirement System and Mercantile National Bank(3)
10.16 Office Sublease at 1840 Century Park East, Los Angeles, California, dated December 16, 1992 by and
between Mercantile National Bank and Charleston, Revich & Williams(3)
10.17 Sublease Agreement at 1840 Century Park East, Los Angeles, California, dated as of July 3, 1986
between Mercantile National Bank and The Lewis Horwitz Organization, as amended by Sublease
Amendment and Option Exercise Agreement dated as of July 1, 1992(3)
10.18 Lease Restructure Agreement dated December 31, 1995 by and between California State Teachers'
Retirement System and Mercantile National Bank.
10.19 Warrant Agreement dated December 31, 1995 by and between National Mercantile Bancorp and California
State Teachers' Retirement System.
10.20 Registration Rights Agreement dated December 31, 1995 by and between the Company and California
State Teachers' Retirement System.
10.21 National Mercantile Bancorp 1983 Stock Option Plan, as amended March 22, 1991(2)
10.22 Form of Stock Option Agreement under the 1983 Stock Option Plan(3)
10.23 National Mercantile Bancorp 1990 Stock Option Plan (filed as Exhibit A to the Company's Proxy
Statement dated May 24, 1990 and incorporated herein by reference)
10.24 Form of Stock Option Agreement under the 1990 Stock Option Plan(3)
10.25 National Mercantile Bancorp 1994 Stock Option Plan (filed as Exhibit A to the Company's Proxy
Statement dated April 18, 1994 and incorporated herein by reference)
10.26 Form of Stock Option Agreement under the 1994 Stock Option Plan(5)
10.27 Form of Severance Agreement between the Company, Mercantile National Bank and some of its officers
(filed as an Exhibit to the Company's Report on Form 10-Q for the quarter ended June 30, 1995 and
incorporated herein by reference)
10.28 Form of Stay Bonus Agreement between the Company, Mercantile National Bank and some of its officers
(filed as an Exhibit to the Company's Report on Form 10-Q for the quarter ended September 30, 1995
and incorporated herein by reference)
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85
Exhibit
No.
- ------
11. Statement regarding computation of per share earnings (see "Note 1 -- Summary of Significant
Accounting Policies -- Income (Loss) Per Share" -- of the "Notes to the Consolidated Financial
Statements" in "Item 8. Financial Statements" in this Annual Report on Form 10-K)
22. Subsidiaries of the Registrant
24.1 Consent of Deloitte & Touche LLP, Independent Auditors
- ---------------
(1) Filed as an exhibit to the Company's Annual Report on Form 10-K for the year
ended December 31, 1990 and incorporated herein by reference
(2) Filed as an exhibit to the Company's Annual Report on Form 10-K for the year
ended December 31, 1991 and incorporated herein by reference
(3) Filed as an exhibit to the Company's Annual Report on Form 10-K for the year
ended December 31, 1992 and incorporated herein by reference
(4) Filed as an exhibit to the Company's Annual Report on Form 10-K for the year
ended December 31, 1993 and incorporated herein by reference
(5) Filed as an exhibit to the Company's Annual Report on Form 10-K for the year
ended December 31, 1994 and incorporated herein by reference
83