UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND - --- EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2000 OR TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 For the transition period from ________to _________. Commission file number 0-25034 GREATER BAY BANCORP (Exact name of registrant as specified in its charter) California 77-0387041 (State or other jurisdiction of (IRS Employer incorporation or organization) Identification No.) 2860 West Bayshore Road, Palo Alto, California 94303 (Address of principal executive offices) (Zip Code) (650) 813-8200 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- Outstanding shares of Common Stock, no par value, as of May 10, 2000: 14,758,423 GREATER BAY BANCORP INDEX Part I. Financial Information Item 1. Consolidated Financial Statements Consolidated Balance Sheets as of March 31, 2000 and December 31, 1999............................................................ 3 Consolidated Statements of Operations for the Three Months Ended March 31, 2000 and 1999.............................................. 4 Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2000 and 1999.............................................. 5 Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2000 and 1999...................................................... 6 Notes to Consolidated Financial Statements...................................................... 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.................................................................. 13 Item 3. Quantitative and Qualitative Disclosures About Market Risk........................................... 30 Part II. Other Information Item 1. Legal Proceedings.................................................................................... 35 Item 2. Changes in Securities and Use of Proceeds............................................................ 35 Item 3. Default Upon Senior Securities....................................................................... 35 Item 4. Submission of Matters to a Vote of Securities Holders................................................ 35 Item 5. Other Information.................................................................................... 35 Item 6. Exhibits and Reports on Form 8-K..................................................................... 35 Signatures...................................................................................... 37 2 GREATER BAY BANCORP AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS March 31, 2000 December 31, (Dollars in thousands) (unaudited) 1999 - ------------------------------------------------------------------------------------------------------------------- ASSETS Cash and due from banks $ 138,937 $ 107,591 Federal funds sold 284,300 200,550 Other short term securities 805 30,257 ---------------------------------- Cash and cash equivalents 424,042 338,398 Investment securities: Available for sale, at fair value 339,450 332,133 Held to maturity, at amortized cost (fair value $220,587 and $136,481 at March 31, 2000 and December 31, 1999, respectively) 225,892 141,725 Other securities 19,817 21,311 ---------------------------------- Investment securities 585,159 495,169 Loans: Commercial 917,326 810,399 Term real estate-commercial 522,852 484,076 ---------------------------------- Total commercial 1,440,178 1,294,475 Real estate construction and land 441,085 417,326 Real estate-other 97,437 92,688 Consumer and other 111,269 123,528 Deferred loan fees and discounts (7,321) (6,840) ---------------------------------- Total loans, net of deferred fees 2,082,648 1,921,177 Allowance for loan losses (44,820) (40,421) ---------------------------------- Total loans, net 2,037,828 1,880,756 Property, premises and equipment 21,443 23,878 Interest receivable and other assets 129,170 107,887 ---------------------------------- Total assets $3,197,642 $2,846,088 ================================== LIABILITIES AND SHAREHOLDERS' EQUITY Deposits: Demand, noninterest-bearing $ 627,116 $ 514,482 MMDA, NOW and savings 1,668,289 1,463,517 Time certificates, $100,000 and over 476,975 434,540 Other time certificates 73,086 93,847 ---------------------------------- Total deposits 2,845,466 2,506,386 Other borrowings 41,100 69,100 Other liabilities 53,226 47,007 ---------------------------------- Total liabilities 2,939,792 2,622,493 ---------------------------------- Company obligated mandatorily redeemable cumulative trust preferred securities of subsidiary trust holding solely junior subordinated debentures 59,500 50,000 Commitments and contingencies SHAREHOLDERS' EQUITY Preferred stock, no par value: 4,000,000 shares authorized; none issued - - Common stock, no par value: 24,000,000 shares authorized; 14,458,592 and 13,964,065 shares issued and outstanding as of March 31, 2000 and December 31, 1999, respectively 112,530 100,690 Accumulated other comprehensive loss (6,237) (5,036) Retained earnings 92,057 77,941 ---------------------------------- Total shareholders' equity 198,350 173,595 ---------------------------------- Total liabilities and shareholders' equity $3,197,642 $2,846,088 ================================== See notes to consolidated financial statements. 3 GREATER BAY BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) Three Months Ended March 31, -------------------------------------- (Dollars in thousands, except per share amounts) 2000 1999 - ----------------------------------------------------------------------------------------------------------------------------- INTEREST INCOME Interest on loans $ 47,679 $ 32,237 Interest on investment securities: Taxable 7,945 5,061 Tax - exempt 1,302 875 ------------------------------------------ Total interest on investment securities 9,247 5,936 Other interest income 4,304 1,976 ------------------------------------------ Total interest income 61,230 40,149 ------------------------------------------ INTEREST EXPENSE Interest on deposits 22,820 13,787 Interest on long term borrowings 1,076 1,054 Interest on other borrowings 956 1,088 ------------------------------------------ Total interest expense 24,852 15,929 ------------------------------------------ Net interest income 36,378 24,220 Provision for loan losses 5,227 1,163 ------------------------------------------ Net interest income after provision for loan losses 31,151 23,057 ------------------------------------------ OTHER INCOME Loan and international banking fees 991 449 Trust fees 924 721 Service charges and other fees 811 712 ATM network revenue 425 515 Gain on sale of SBA loans 108 302 Loss on sale of investments, net (1) - Other income 2,827 419 ------------------------------------------ Total, recurring 6,085 3,118 Warrant income, net 8,609 4 ------------------------------------------ Total other income 14,694 3,122 ------------------------------------------ OPERATING EXPENSES Compensation and benefits 10,979 8,714 Occupancy and equipment 3,917 3,026 Legal and other professional fees 806 580 Telephone, postage and supplies 720 718 Marketing and promotion 564 462 Client services 500 439 FDIC insurance and regulatory assessments 202 117 Directors fees 109 209 Other real estate owned 10 21 Other 1,528 1,148 ------------------------------------------ Total, recurring 19,335 15,434 Merger and other related nonrecurring costs 3,881 - ------------------------------------------ Total operating expenses 23,216 15,434 ------------------------------------------ Income before provision for income taxes and extraordinary items 22,629 10,745 Provision for income taxes 9,156 4,181 ------------------------------------------ Net income before extraordinary items 13,473 6,564 Extraordinary items - (88) ------------------------------------------ Net income $ 13,473 $ 6,476 ========================================== Net income per share - basic $ 0.96 $ 0.50 ========================================== Net income per share - diluted $ 0.91 $ 0.46 ========================================== See notes to consolidated financial statements. 4 GREATER BAY BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED) Three Months Ended March 31, --------------------------------------- (Dollars in thousands) 2000 1999 - --------------------------------------------------------------------------------------------------------------------------- Net income $ 13,473 $ 6,476 --------------------------------------- Other comprehensive income: Unrealized gains on securities: Unrealized holding losses arising during period (net of taxes of $(1,015) and $(314) for the three months ended March 31, (1,451) (449) 2000 and 1999, respectively) Reclassification adjustment for gains included in net income 1 - --------------------------------------- Net change (1,452) (449) Cash flow hedge: Net derivative gains arising during period (net of taxes of $177 and $586 for the three months ended March 31, 2000 and 1999, respectively) 253 838 Reclassification adjustment for expenses included in net income (net of taxes of $1 and $(30) for the three months ended March 31, 2000 and 1999, respectively) 2 (43) --------------------------------------- Net change 251 881 --------------------------------------- Other comprehensive income (1,201) 432 --------------------------------------- Comprehensive income $ 12,272 $ 6,908 ======================================= See notes to consolidated financial statements. 5 GREATER BAY BANCORP AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) Three Months Ended March 31, -------------------------------------- (Dollars in thousands) 2000 1999 - ------------------------------------------------------------------------------------------------------------- Cash flows - operating activities Net income $ 13,473 $ 6,476 Reconcilement of net income to net cash from operations: Provision for loan losses 5,227 1,163 Depreciation and amortization 1,476 1,056 Deferred income taxes (1,810) (251) (Gain) loss on sale of investments, net - - Changes in: Accrued interest receivable and other assets (16,109) (1,323) Accrued interest payable and other liabilities 6,646 3,779 Deferred loan fees and discounts, net 481 819 --------------- --------------- Operating cash flows, net 9,384 11,719 --------------- --------------- Cash flows - investing activities Maturities and partial paydowns on of investment securities: Held to maturity 13,904 4,094 Available for sale - 19,712 Purchase of investment securities: Held to maturity (98,098) (7,320) Available for sale (9,896) (83,944) Other securities 1,494 (47) Proceeds from sale of available for sale securities - 59,545 Loans, net (162,780) (159,650) Proceeds from sale of other real estate owned - 345 Purchase of property, premises and equipment, net 1,097 (2,679) Purchase of insurance policies (2,524) (1,935) --------------- --------------- Investing cash flows, net (256,803) (171,879) --------------- --------------- Cash flows - financing activities Net change in deposits 339,080 225,453 Net change in other borrowings - short term (28,000) (10,695) Principal repayment - long term borrowings - (3,000) Company obligated madatorially redeemable preferred securities of subsidiary trust holding solely junior subordinated debentures issued (proceeds from issuance of) 9,500 - Proceeds from sale of common stock 14,750 1,793 Cash dividends (2,267) (1,764) --------------- --------------- Financing cash flows, net 333,063 211,787 --------------- --------------- Net change in cash and cash equivalents 85,644 51,627 Cash and cash equivalents at beginning of period 338,398 239,285 --------------- --------------- Cash and cash equivalents at end of period $ 424,042 $ 290,912 =============== =============== Cash flows - supplemental disclosures Cash paid during the period for: Interest $ 26,306 $ 35,791 Income taxes $ 810 $ 7,729 Non-cash transactions: Additions to other real estate owned $ - $ 105 See notes to consolidated financial statements. 6 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS As of March 31, 2000 and December 31, 1999 and for the Three Months Ended March 31, 2000 and 1999 NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES The Consolidated Balance Sheet as of March 31, 2000, and the Consolidated Statements of Operations, Comprehensive Income and Cash Flows for the three months ended March 31, 2000 have been prepared by Greater Bay Bancorp (the "Company" ) and are not audited. The results of operations for the quarter ended March 31, 2000 are not necessarily indicative of the results expected for any subsequent quarter or for the entire year ended December 31, 2000. Consolidated financial statements should be read in conjunction with the consolidated financial statements in the Current Report on Form 8-K filed on February 1, 2000. Consolidation and Basis of Presentation The unaudited financial information presented was prepared on the same basis as the audited financial statements for the year ended December 31, 1999. The consolidated financial statements include the accounts of Greater Bay Bancorp ("Greater Bay" on a parent-only basis, and the "Company" on a consolidated basis) and its wholly owned subsidiaries, Bay Area Bank ("BAB"), Bay Bank of Commerce ("BBC"), Cupertino National Bank ("CNB"), Golden Gate Bank ("Golden Gate"), Mid-Peninsula Bank ("MPB"), Mt. Diablo National Bank ("MDNB"), Peninsula Bank of Commerce ("PBC"), GBB Capital I, GBB Capital II and GBB Capital III and its operating divisions. All significant intercompany transactions and balances have been eliminated. Certain reclassifications have been made to prior periods consolidated financial statements to conform to the current presentation. In the opinion of management such unaudited financial statements reflect all adjustments necessary for fair statement of the results of operations and balances for the interim period presented. The accounting and reporting policies of the Company conform to generally accepted accounting principles and the prevailing practices within the banking industry. 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 certain assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of certain revenues and expenses during the reporting period. Actual results could differ from those estimates. Comprehensive Income Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income" requires the Company to classify items of other comprehensive income by their nature in the financial statements and display the accumulated other comprehensive income separately from retained earnings in the equity section of the balance sheet. The changes to the balances of accumulated other comprehensive income are as follows: Accumulated Other (Dollars in thousands) Unrealized Gains Cash Flow Comprehensive on Securities Hedges Income ------------------------------------------------------------------------------------------------------------------ Balance - December 31, 1999 $ (6,540) $ 1,504 $ (5,036) Current period change (1,452) 251 (1,201) ------------------------------------------------------------ Balance - March 30, 2000 $ (7,992) $ 1,755 $ (6,237) ============================================================ Accumulated Other (Dollars in thousands) Unrealized Gains Cash Flow Comprehensive on Securities Hedges Income - ------------------------------------------------------------------------------------------------------------------ Balance - December 31, 1998 $ 709 $ (677) $ 32 Current period change (449) 881 432 ------------------------------------------------------------ Balance - March 30, 1999 $ 260 $ 204 $ 464 ============================================================ 7 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) As of March 31, 2000 and December 31, 1999 and for the Three Months Ended March 31, 2000 and 1999 Segment Information In 1998, the Company adopted SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information" ("SFAS No. 131".) SFAS No. 131 supersedes SFAS No. 14, "Financial Reporting for Segments of a Business Enterprise", replacing the "industry segment" approach with the "management" approach. The management approach designates the internal organization that is used by management for making operating decisions and assessing performance as the source of the company's reportable segments. SFAS No. 131 also requires disclosures about products and services, geographic areas, and major customers. The adoption of SFAS No. 131 did not affect results of operations or financial position but did affect the disclosure of segment information. NOTE 2--MERGERS On December 14, 1999, Greater Bay and Coast Bancorp, the holding company of Coast Commercial Bank ("CCB"), a California state chartered bank, signed a definitive agreement for a merger between the two companies, as a result of which CCB will become a wholly owned subsidiary of Greater Bay. The agreement provides for Coast Bancorp shareholders to receive approximately 3,105,000 shares of Greater Bay stock subject to certain adjustments based on movements in Greater Bay's stock price, in a tax -free exchange to be accounted for as a pooling-of-interests. The transaction is expected to be completed in the second quarter of 2000, subject to regulatory and shareholder approvals. On January 26, 2000, Greater Bay, Bank of Santa Clara ("BSC") and GBB Merger Corp. signed a definitive agreement for a merger between BSC and GBB Merger Corp., as a result of which BSC will become a wholly owned subsidiary of Greater Bay. The agreement provides for BSC shareholders to receive approximately 2,017,000 shares of Greater Bay stock subject to certain adjustments based on movements in Greater Bay's stock price in a tax-free exchange to be accounted for as a pooling-of-interests. The transaction is expected to be completed in the early third quarter of 2000, subject to regulatory and shareholder approvals. On March 21, 2000, Greater Bay, Bank of Petaluma ("BOP") and DKSS Corp. signed a definitive agreement for a merger between BOP and DKSS, as a result of which BOP will become a wholly owned subsidiary of Greater Bay. The agreement provides for BOP shareholders to receive approximately 990,000 shares of Greater Bay stock subject to certain adjustments based on changes in the Company's stock price in a tax-free exchange to be accounted for as a pooling-of-interests. The transaction is expected to be completed in the fourth quarter of 2000, subject to BOP's shareholders and regulatory approvals. 8 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) As of March 31, 2000 and December 31, 1999 and for the Three Months Ended March 31, 2000 and 1999 The following table sets forth certain historical information concerning the operations of the Company, Coast Bancorp, BSC and BOP for the period indicated and proforma combined information assuming the acquisitions had been consummated at the beginning of the period presented. For the three months ended (Dollars in thousands) March 31, 2000 - ------------------------------------------------------------------------- Net interest income: Greater Bay Bancorp $ 36,378 Coast Bancorp 5,538 BSC 4,958 BOP 2,231 --------------- Combined $ 49,105 =============== Provision for loan losses: Greater Bay Bancorp $ 5,227 Coast Bancorp 87 BSC 225 BOP 15 --------------- Combined $ 5,554 =============== Net income: Greater Bay Bancorp $ 13,473 Coast Bancorp 2,035 BSC 1,221 BOP 567 --------------- Combined $ 17,296 =============== There are currently no significant transactions between the Company and each of Coast Bancorp, BSC and BOP. 9 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) As of March 31, 2000 and December 31, 1999 and for the Three Months Ended March 31, 2000 and 1999 NOTE 3--PROPERTY, PREMISES AND EQUIPMENT During the first quarter of 2000, the Company sold bank premises with a carrying value of $4.8 million for $5.4 million in a sale-lease back transaction. No gain was recognized on the transaction. Gains of $535,000 have been deferred and will be recognized over the term of the Company's lease. NOTE 4--BORROWINGS Other borrowings are detailed as follows: March 31, December 31, (Dollars in thousands) 2000 1999 - ---------------------------------------------------------------------------------------- Other borrowings: Short term borrowings: Securities sold under agreements to repurchase $ - $ 40,100 Short term notes payable 100 - Fed Fund Purchases 14,000 - Advances under credit lines 25,000 7,000 ------------------------------- Total short term borrowings 39,100 47,100 ------------------------------- Long term borrowings: Securities sold under agreements to repurchase - 10,000 FHLB advances 2,000 12,000 ------------------------------- Total other long term borrowings 2,000 22,000 ------------------------------- Total other borrowings $ 41,100 $ 69,100 =============================== During the three month period ended March 31, 2000 and the twelve month period ended December 31, 1999, the average balance of securities sold under short term agreements to repurchase were $30.3 million and $14.8 million, respectively, and the average interest rates during those periods were 5.89% and 5.64%, respectively. Securities sold under short term agreements to repurchase generally mature within 90 days of dates of purchase. During the three month period ended March 31, 2000 and the twelve month period ended December 31, 1999, the average balance of federal funds purchased was $154,000 and $186,000, respectively, and the average interest rates during those periods were 6.50% and 5.29%, respectively. There were $14.0 million outstanding at March 31, 2000 and no such balances outstanding at December 31, 1999. The FHLB advances will mature in the year 2003 and have an average interest rate of 5.47%. The advances are collateralized by securities pledged to the FHLB. Under the terms of the advances, the FHLB has a put option which gives it the right to demand early repayment. 10 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) As of March 31, 2000 and December 31, 1999 and for the Three Months Ended March 31, 2000 and 1999 NOTE 5--PER SHARE DATA Net income per share is stated in accordance with SFAS No. 128 "Earnings Per Share". Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the year. Diluted net income per share is computed by dividing net income by the weighted average number of common shares plus common equivalent shares outstanding including dilutive stock options. The following table provides a reconciliation of the numerators and denominators of the basic and diluted net income per share computations for the three months ended March 31, 2000 and 1999. For the three months For the three months ended March 31, 2000 ended March 31, 199 ----------------------------------------- ------------------------------------ Average Average Income Shares Per Share Income Shares Per Share (Dollars in thousands, except per share amounts) (Numerator) (Denominator) Amount (Numerator) (Denominator) Amount - --------------------------------------------------------------------------------------------- ---------------------------------- Net income $ 13,473 $ 6,476 Basic net income per share: Income available to common shareholders 13,473 14,031,000 $ 0.96 6,476 13,053,000 $ 0.50 Effect of dilutive securities: Stock options - 732,000 - - 920,000 - ------------------------------------------ --------------------------------- Diluted net income per share: Income available to common shareholders and assumed conversions $ 13,473 14,763,000 $ 0.91 $ 6,476 13,973,000 $ 0.46 ------------------------------------------ --------------------------------- There were options to purchase 6,475 and 475,125 shares that were considered anti-dilutive whereby the options' exercise price was greater than the average market price of the common shares, during the three months ended March 31, 2000 and 1999, respectively. Weighted average shares outstanding and all per share amounts included in the consolidated financial statements and notes thereto are based upon the increased number of shares giving retroactive effect to the 2000 merger with Mt. Diablo Bancshares ("MD Bancshares") at a 0.9532 conversion ratio and the 1999 mergers with Bay Commercial Services ("BCS") at a 0.6833 conversion ratio and Bay Area Bancshares ("BA Bancshares") at a 1.38682 conversion ratio. NOTE 6--ACTIVIY OF BUSINESS SEGMENTS The Company adopted SFAS No. 131. The accounting policies of the segments are the same as those described in the "Summary of Significant Accounting Policies." Segment data includes intersegment revenue, as well as charges allocating all corporate-headquarters costs to each of its operating segments. The Company evaluates the performances of its segments and allocates resources to them based on net interest income, other income, net income before income taxes, total assets and deposits. 11 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) As of March 31, 2000 and December 31, 1999 and for the Three Months Ended March 31, 2000 and 1999 The Company is organized primarily along community banking and trust divisions. Thirteen of the divisions have been aggregated into the "community banking" segment. Community banking provides a range of commercial banking services to small and medium-sized businesses, real estate developers, property managers, business executives, professional and other individuals. The trust division has been shown as the "trust operations" segment. The Company's business is conducted principally in the U.S.; foreign operations are not material. The following table shows each segment's key operating results and financial position for the three months ended March 31, 2000 and 1999: Three Months Ended Three Months Ended March 31, 2000 March 31, 1999 --------------------------------------- ------------------------------------- Community Trust Community Trust (Dollars in thousands) Banking Operations Banking Operations - ------------------------------------------------------------------------------------------------------------------------------------ Net interest income $ 36,907 $ 118 $ 25,046 $ 57 Other income 13,804 863 2,319 725 Operating expenses, excluding merger and other related nonrecurring costs 20,190 650 15,178 718 Net income before income taxes, merger, and other related costs and extraordinary items (1) 25,339 286 11,097 (9) Total assets 3,129,548 - 2,246,069 - Deposits 2,783,363 62,103 1,938,283 45,477 Assets under management - 751,677 - 630,490 (1) Includes intercompany earnings allocation charge which is eliminated in consolidation. A reconciliation of total segment net interest income and other income combined, net income before income taxes, and total assets to the consolidated numbers in each of these categories for the three months ended March 31, 2000 and 1999 is presented below. Three Months Ended Three Months Ended March 31, 2000 March 31, 1999 ------------------- ------------------- Net interest income and other income Total segment net interest income and other income $ 51,692 $ 28,147 Parent company net interest income and other income (620) (805) ------------------- ------------------- Consolidated net interest income and other income $ 51,072 $ 27,342 =================== =================== Net income before taxes, merger related nonrecurring costs and extraordinary items Total segment net income before taxes $ 25,625 $ 11,088 Parent company net income before taxes 885 (343) Consolidated net income before taxes merger and other related costs and ------------------- ------------------- extraordinary items $ 26,510 $ 10,745 =================== =================== Total assets Total segment assets $ 3,129,548 $ 2,246,069 Parent company assets 68,094 24,225 ------------------- ------------------- Consolidated total assets $ 3,197,642 $ 2,270,294 =================== =================== NOTE 7--CASH DIVIDEND The Company declared a cash dividend of $0.15 cents per share payable on April 15, 2000 to shareholders of record as of March 31, 2000. 12 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Greater Bay is a bank holding company operating BAB, BBC, CNB, Golden Gate, MPB, MDNB, and PBC. The Company also owns and operates GBB Capital I, GBB Capital II, and GBB Capital III which are Delaware statutory business trusts, which were formed for the exclusive purpose of issuing and selling Cumulative Trust Preferred Securities ("TPS"). Greater Bay also includes the operating divisions: Greater Bay Bank Contra Costa Region, Greater Bay Bank Fremont Region, Greater Bay Bank Santa Clara Valley Commercial Banking Group, Greater Bay Bank SBA Lending Group, Greater Bay Corporate Finance Group, Greater Bay International Banking Division, Greater Bay Trust Company, Pacific Business Funding and the Venture Banking Group. The Company provides a wide range of commercial banking services to small and medium-sized businesses, real estate developers, property managers, business executives, professionals and other individuals. The Company operates throughout the Silicon Valley, San Francisco, the San Francisco Peninsula and the East Bay region, with 19 offices located in Blackhawk, Cupertino, Danville, Fremont, Hayward, Lafayette, Millbrae, Palo Alto, Pleasanton, Redwood City, San Francisco, San Jose, San Leandro, San Mateo, San Ramon, Santa Clara and Walnut Creek. The following discussion and analysis is intended to provide greater details of the results of operations and financial condition of the Company. The following discussion should be read in conjunction with the Company's consolidated financial data included elsewhere in this document. Certain statements under this caption constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which involve risks and uncertainties. The Company's actual results may differ significantly from the results discussed in such forward-looking statements. Factors that might cause such a difference include but are not limited to economic conditions, competition in the geographic and business areas in which the Company conducts its operations, fluctuation in interest rates, credit quality and government regulation. RESULTS OF OPERATIONS Net income for the first quarter of 2000 increased 107.7% to $13.5 million, or $0.91 per diluted share, compared to net income of $6.5 million, or $0.46 per diluted share, for the first quarter of 1999. The first quarter 2000 results included nonrecurring warrant income of $8.6 million compared to nonrecurring warrant income of $4,000 during the first quarter of 1999. In addition, the first quarter of 2000 included nonrecurring merger related costs and extraordinary items of $2.4 million compared to nonrecurring merger related costs and extraordinary items of $88,000 in the first quarter of 1999. As a result, net income, including nonrecurring warrant income and excluding nonrecurring merger related expenses and extraordinary items, increased 140.9% to $15.9 million, or $1.07 per diluted share, for the first quarter of 2000, compared to $6.6 million, or $0.47 per diluted share, in the first quarter of 1999. Greater Bay Bancorp's core earnings, which is its net income, excluding nonrecurring warrant income, merger related costs and extraordinary items, for the first quarter of 2000 increased 65.3% to $10.8 million, or $0.73 per diluted share, compared to $6.6 million, or $0.47 per diluted share, in the first quarter of 1999. Based on its core earnings for the first quarter of 2000, Greater Bay Bancorp's return on average equity was 23.75%, its return on average assets was 1.43% and its efficiency ratio was 45.53%. During the first quarter of 1999, Greater Bay Bancorp's core earnings resulted in return on average equity of 20.04%, return on average assets of 1.25% and an efficiency ratio of 56.46%. 13 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The following table summarizes net income, net income per share and key financial ratios inclusive of and exclusive of merger, nonrecurring and extraordinary items for the three month periods presented: Income before merger, nonrecurring and extraordinary items ----------------------------------------- (Dollars in thousands, except per share amounts) March 31, 2000 March 31, 1999 ----------------------------------------- Income $ 10,843 $ 6,562 Income per share: Basic $ 0.77 $ 0.50 Diluted $ 0.73 $ 0.47 Return on average assets 1.43% 1.25% Return on average shareholders' equity 23.75% 20.04% Income after technology gains and before merger and extraordinary items ---------------------------------------------- (Dollars in thousands, except per share amounts) March 31, 2000 March 31, 1999 ---------------------------------------------- Income $ 15,862 $ 6,560 Income per share: Basic $ 1.13 $ 0.50 Diluted $ 1.07 $ 0.47 Return on average assets 2.10% 1.25% Return on average shareholders' equity 34.75% 20.04% Income after merger, nonrecurring and extraordinary items -------------------------------------------- (Dollars in thousands, except per share amounts) March 31, 2000 March 31, 1999 -------------------------------------------- Income $ 13,473 $ 6,476 Income per share: Basic $ 0.96 $ 0.50 Diluted $ 0.91 $ 0.46 Return on average assets 1.78% 1.23% Return on average shareholders' equity 29.43% 19.78% The Company reported net income of $13.5 million for the three months ended March 31, 2000, a 108.0% increase over the three months ended March 31, 1999 net income of $6.5 million. Basic net income per share was $0.96 for the three months ended March 31, 2000, as compared to $0.50 for the three months ended March 31, 1999. Diluted net income per share was $0.91 and $0.46 for the three months ended March 31, 2000 and 1999, respectively. The return on average assets and return on average shareholders' equity were 1.78% and 29.43% for the three months ended March 31, 2000, compared with 1.23% and 19.78% for the three months ended March 31, 1999. The 107.7% increase in 2000 net income as compared to 1999 was the result of significant growth in loans, investments, trust assets and deposits. For the three months ended March 31, 2000, net interest income increased 50.2% as compared to the three months ended March 31, 1999. This increase was primarily due to a 43.9% increase in average interest-earning assets for the three months ended March 31, 2000 compared to the three months ended March 31, 1999. The increases in loans, trust assets and deposits also contributed to the 44.8% increase in trust fees, loan and international banking fees, service charges and other fees. Other income includes $2.1 million in appreciation recognized on the conversion of equity securities received in the settlement of a loan into a publicly traded equity security. Increases in operating expenses were required to service and support the Company's growth. As a result, increases in revenue were partially offset for the three months ended March 31, 2000 by a 25.3% increase in recurring operating expenses, as compared to the three months ended March 31, 1999. For the three months ended March 31, 2000, merger and related nonrecurring costs were $2.4 million, net of taxes, as compared to $0 the three months ended March 31, 1999. Warrant income, net of related expenses and taxes, was $5.1 million for the three months ended March 31, 2000 as compared to $2,000 for the three months ended March 31, 1999. 14 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Net Interest Income The following table presents, for the quarters indicated, condensed average balance sheet information for the Company, together with interest income and yields earned on average interest-earning assets and interest expense and rates paid on average interest-bearing liabilities. Average balances are average daily balances. Three Months Ended March 31, 2000 ----------------------------- Average Average Yield/ (Dollars in thousands) Balance(1) Interest Rate - -------------------------------------------------------------------------------------------------------- INTEREST-EARNING ASSETS: Fed funds sold $ 260,274 $ 3,836 5.91% Other short term securities 30,583 468 6.14% Investment securities: Taxable 453,518 7,945 7.03% Tax-exempt (1) 98,529 1,302 5.30% Loans (2), (3) 1,985,551 47,679 9.63% ----------- ----------- Total interest-earning assets 2,828,455 61,230 8.68% Noninterest-earning assets 215,332 ----------- ----------- Total assets $ 3,043,787 61,230 =========== ----------- INTEREST-BEARING LIABILITIES: Deposits: MMDA, NOW and Savings $ 1,597,507 16,029 4.02% Time deposits, over $100,000 444,527 5,641 5.09% Other time deposits 93,490 1,150 4.93% ----------- ----------- Total interest-bearing deposits 2,135,524 22,820 4.29% Other borrowings 58,375 956 6.57% Subordinated debt - - ----------- ----------- Total interest-bearing liabilities 2,193,899 23,776 4.35% Trust Preferred Securities 50,940 1,076 8.47% ----------- ----------- Total interest-bearing liabilities and capital securities 2,244,839 24,852 4.44% Noninterest-bearing deposits 559,727 Other noninterest-bearing liabilities 55,629 Shareholders' equity 183,592 ----------- Total liabilities and shareholders' equity $ 3,043,787 24,852 =========== ----------- Net interest income $ 36,378 =========== Including capital securities: - ---------------------------------------------------- Interest rate spread 4.24% Contribution of interest free funds 0.92% Net yield on interest-earnings assets (4) 5.16% Excluding capital securities: - ---------------------------------------------------- Interest rate spread 4.34% Contribution of interest free funds 0.98% Net yield on interest-earnings assets (5) 5.31% Three Months Ended December 31, 1999 ----------------------------- Average Average Yield/ (Dollars in thousands) Balance(1) Interest Rate - -------------------------------------------------------------------------------------------------------- INTEREST-EARNING ASSETS: Fed funds sold $ 264,134 $4,161 6.25% Other short term securities 17,365 300 6.85% Investment securities: Taxable 427,344 6,859 6.37% Tax-exempt (1) 91,632 1,108 4.80% Loans (2), (3) 1,814,744 43,140 9.43% ----------- ----------- Total interest-earning assets 2,615,219 55,568 8.43% Noninterest-earning assets 195,887 ----------- ----------- Total assets $ 2,811,106 55,568 =========== ----------- INTEREST-BEARING LIABILITIES: Deposits: MMDA, NOW and Savings $ 1,481,001 14,312 3.83% Time deposits, over $100,000 412,210 4,971 4.78% Other time deposits 96,769 1,146 4.70% ----------- ----------- Total interest-bearing deposits 1,989,980 20,429 4.07% Other borrowings 69,015 1,030 5.92% Subordinated debt - - ----------- ----------- Total interest-bearing liabilities 2,058,995 21,459 4.13% Trust Preferred Securities 50,000 1,054 8.36% ----------- ----------- Total interest-bearing liabilities and capital securities 2,108,995 22,513 4.24% Noninterest-bearing deposits 515,061 Other noninterest-bearing liabilities 35,956 Shareholders' equity 151,094 ----------- Total liabilities and shareholders' equity $ 2,811,106 22,513 =========== ----------- Net interest income $ 33,055 =========== Including capital securities: - ---------------------------------------------------- Interest rate spread 4.19% Contribution of interest free funds 0.82% Net yield on interest-earnings assets (4) 5.01% Excluding capital securities: - ---------------------------------------------------- Interest rate spread 4.30% Contribution of interest free funds 0.88% Net yield on interest-earnings assets (5) 5.17% Three Months Ended March 31, 1999 ----------------------------- Average Average Yield/ (Dollars in thousands) Balance(1) Interest Rate - --------------------------------------------------------------------------------------------------------- INTEREST-EARNING ASSETS: Fed funds sold $ 78,926 $ 914 4.70% Other short term securities 69,493 1,062 6.20% Investment securities: Taxable 337,185 5,061 6.09% Tax-exempt (1) 76,668 875 4.63% Loans (2), (3) 1,403,292 32,237 9.32% ----------- ----------- Total interest-earning assets 1,965,564 40,149 8.28% Noninterest-earning assets 167,831 ----------- ----------- Total assets $ 2,133,395 40,149 =========== ----------- INTEREST-BEARING LIABILITIES: Deposits: MMDA, NOW and Savings $ 1,046,066 8,820 3.42% Time deposits, over $100,000 322,133 3,695 4.65% Other time deposits 114,175 1,272 4.52% ----------- ----------- Total interest-bearing deposits 1,482,374 13,787 3.77% Other borrowings 75,010 1,017 5.50% Subordinated debt 2,443 71 11.79% ----------- ----------- Total interest-bearing liabilities 1,559,827 14,875 3.87% Trust Preferred Securities 50,000 1,054 8.55% ----------- ----------- Total interest-bearing liabilities and capital securities 1,609,827 15,929 4.01% Noninterest-bearing deposits 364,366 Other noninterest-bearing liabilities 26,429 Shareholders' equity 132,773 ----------- Total liabilities and shareholders' equity $ 2,133,395 15,929 =========== ----------- Net interest income $ 24,220 =========== Including capital securities: - ---------------------------------------------------- Interest rate spread 4.27% Contribution of interest free funds 0.73% Net yield on interest-earnings assets (4) 5.00% Excluding capital securities: - ---------------------------------------------------- Interest rate spread 4.42% Contribution of interest free funds 0.80% Net yield on interest-earnings assets (5) 5.21% (1) The tax equivalent yields earned on the tax exempt securities are 7.68%, 6.94% and 6.70% for the quarters ended March 31, 2000, December 31, 1999 and March 31, 1999, respectively, using the federal statuary rate of 34%. (2) Nonaccrual loans are excluded in the average balance. (3) Interest income includes loan fees of $1,420,000, $1,217,000 and $1,165,000 for the quarters ended March 31, 2000, December 31, 1999 and March 31, 1999, respectively. (4) Equals (a) the difference between interest income on interest-earning assets and the interest expense on interest-bearing liabilities and capital securities, divided by (b) average interest-earning assets for the period. (5) Equals (a) the difference between interest income on interest-earning assets and the interest expense on interest-bearing liabilities, divided by (b) average interest-earning assets for the period. 15 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Net interest income, excluding interest expense on the Trust Preferred Securities issued by the Company ("capital securities"), for the first quarter of 2000 was $37.5 million, a $3.4 million increase over the fourth quarter of 1999 and a $12.3 million increase over the first quarter of 1999. The increase from the first quarter of 1999 to the first quarter of 2000 was primarily due to the $862.9 million, or 43.9% increase in average interest-earning assets. The increase from the fourth quarter of 1999 to the first quarter of 2000 was primarily due to the $213.2 million, or 8.15% increase in average interest- earning assets, which was further increased by a 14 basis points increase in the Company's net yield on interest-earning assets from 5.17% in the fourth quarter of 1999 to 5.31% in the first quarter of 2000. The interest rate spread for the quarters ended March 31, 2000, December 31, 1999 and March 31, 1999, were reduced by the low spread earned on PBC's Special Deposits (discussed in Note 7 to the consolidated financial statements and notes thereto included in the Current Report on Form 8-K filed on February 1, 2000. As of March 31, 2000, PBC held $99.7 million in two demand deposits accounts (the "Special Deposits"). The Special Deposits represent the proposed settlement of class action lawsuits not involving the Company. Due to the uncertainty of the time the Special Deposits will remain with PBC, management has invested a significant portion of the funds from this deposit in agency securities with maturities of less than 90 days. The average deposit balances related to the Special Deposits were $101.1 million, $121.5 million and $99.0 million for the quarters ended March 31, 2000, December 31, 1999 and March 31, 1999 respectively, on which the Company earned a spread of approximately 3.05%, 3.10% and 3.00%, respectively. Excluding PBC's Special Deposits, the net yield on interest earning assets would have been 5.40%, 5.28% and 5.33% for the quarters ended March 31, 2000, December 31, 1999 and March 31, 1999 respectively. Excluding the Special Deposits, the approximate interest rate spread would have been 4.27%, 4.23% and 4.35% for the quarters ended March 31, 2000, December 31, 1999 and March 31, 1999 respectively. The purchase of bank- owned life insurance ("BOLI") also reduced the Company's net interest spread since the earnings of BOLI are included in other income while the cost of funding BOLI is included in interest expense. 16 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The most significant impact on the Company's net interest income between periods is derived from the interaction of changes in the volume of and rate earned or paid on interest-earning assets and interest-bearing liabilities. The volume of interest-earning asset dollars in loans and investments, compared to the volume of interest-bearing liabilities represented by deposits and borrowings, combined with the spread, produces the changes in the net interest income between periods. The table below sets forth, for the quarters indicated, a summary of the changes in interest income and interest expense due to average asset and liability balances (volume) and due to changes in average interest rates (rate). Changes in interest income and expense which are not attributable specifically to either volume or rate, are allocated proportionately between both variances. Nonaccrual loans are excluded from average loans. The impact of capital securities is not included in this table. Three months Ended March 31, 2000 Compared with December 31, 1999 favorable (unfavorable) -------------------------------------------------- (Dollars in thousands) Volume Rate Net - --------------------------------------------------------------------- -------------- --------------- INTEREST-EARNING ASSETS: Fed funds sold $ (69) $ (256) $ (325) Other short term securities 202 (34) 168 Investment securities: Taxable 404 682 1,086 Tax-exempt 81 113 194 Loans 3,703 836 4,539 -------- -------- -------- Total interest-earning assets 4,321 1,341 5,662 -------- -------- -------- INTEREST-BEARING LIABILITIES: Deposits: MMDA, NOW and Savings (1,052) (665) (1,717) Time deposits, over $100,000 (369) (301) (670) Other time deposits 44 (48) (4) -------- -------- -------- Total interest-bearing deposits (1,377) (1,014) (2,391) Other borrowings 174 (100) 74 Subordinated debt -- -- -- -------- -------- -------- Total interest-bearing liabilities (1,203) (1,114) (2,317) -------- -------- -------- Increase (decrease) in net interest income $ 3,118 $ 227 $ 3,345 ======== ======== ======== Three months Ended March 31, 2000 Compared with March 31, 1999 favorable (unfavorable) -------------------------------------------------- (Dollars in thousands) Volume Rate Net - --------------------------------------------------------------------- -------------- --------------- INTEREST-EARNING ASSETS: Fed funds sold $ 2,626 $ 296 $ 2,922 Other short term securities (584) (10) (594) Investment securities: Taxable 1,993 891 2,884 Tax-exempt 283 144 427 Loans 14,278 1,164 15,442 -------- -------- -------- Total interest-earning assets 18,596 2,485 21,081 -------- -------- -------- INTEREST-BEARING LIABILITIES: Deposits: MMDA, NOW and Savings (5,397) (1,812) (7,209) Time deposits, over $100,000 (1,559) (387) (1,946) Other time deposits 238 (116) 122 -------- -------- -------- Total interest-bearing deposits (6,718) (2,315) (9,033) Other borrowings 246 (185) 61 Subordinated debt 36 35 71 -------- -------- -------- Total interest-bearing liabilities (6,436) (2,465) (8,901) -------- -------- -------- Increase (decrease) in net interest income $ 12,160 $ 20 $ 12,180 ======== ======== ======== The Quarter Ended March 31, 2000 compared to March 31, 1999 ----------------------------------------------------------- Interest income in the first quarter ended March 31, 2000 increased 52.5% to $61.2 million from $40.1 million in the same period in 1999. This was primarily due to the $18.6 million favorable volume variance which resulted from a $862.9 million, or 43.9%, increase in average interest-earning assets over the comparable prior year. Average loans increased $582.3 million, or 41.5%, to 2.0 billion for the first quarter of 2000 as compared to $1.4 billion for the first quarter of 1999. The average yield on interest-earning assets increased 40 basis points to 8.68% in the first quarter of 2000 from 8.28% in the same period of 1999 primarily due to the increase on the yields on loans. Average yields on loans increased 31 basis points to 9.63% in the three months ended March 31, 2000 from 9.32% for the same period in 1999, primarily as a result of increases in market rates of interest. Interest expense, excluding capital securities, in the first quarter of 2000 increased 59.1% to $23.8 million from $14.9 million for the same period in 1999. This increase was due to an increase in average interest-bearing liabilities and higher interest rates paid on interest-bearing liabilities. Average interest-bearing liabilities increased 40.7% to $2.2 billion in the first quarter of 2000 from $1.6 billion in the same period for 1999 due to the efforts of the Company's relationship managers in generating core deposits from their client relationships, deposits derived from the activities of the Greater Bay Trust Company and the Venture Banking Group. 17 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) As a result of the foregoing, the Company's interest rate spread excluding capital securities increased to 4.34% in the first quarter of 2000 compared to 4.42% in the same quarter one year earlier and the net yield on interest-earning assets increased to 5.31% from 5.21%. During the first quarter of 2000, average noninterest-bearing deposits increased to $559.7 million from $364.4 million in the same period in 1999. Average noninterest-bearing deposits comprised 20.8% of total deposits for the first quarter in 2000, compared to 19.7% for the same period in 1999. The Quarter Ended March 31, 2000, compared to December 31, 1999 --------------------------------------------------------------- Interest income increased 10.2% to $61.2 million for the first quarter of 2000, as compared to $55.6 million for the previous quarter. Average interest- earning assets increased 8.15% in the first quarter of 2000 from $2.6 billion for the previous quarter. The increase in interest income for the first quarter of 2000, as compared to the prior quarter, was primarily the result of an increase in the average balances of loans which increased $170.8 million and investment securities which grew $33.1 million from the prior quarter. The impact of increases in average balances on loans was enhanced by an increase in the yield earned on those assets. The yield on the average interest-earning assets increased 25 basis points to 8.68% in the first quarter of 2000 from 8.43% in the fourth quarter of 1999, primarily as a result of increases in market rates of interest. Interest expense, excluding capital securities, in the first quarter of 2000 increased 10.4% to $23.8 million from $21.5 million in the prior quarter. The increase is the result of increased interest-bearing liabilities, which rose to $2.2 billion for the first quarter of 2000, as compared to $2.1 billion for the prior quarter, and a 22 basis point increase in the cost of funds which increased to 4.35% in the first quarter of 2000. As a result of the foregoing, the Company's interest rate spread excluding capital securities increased to 4.34% in the first quarter of 2000 compared to 4.30% in the prior quarter and the net yield on interest-earning assets increased to 5.31% from 5.17%. During the first quarter of 2000, average noninterest-bearing deposits increased to $559.7 million from $515.1 million in the fourth quarter of 1999. Average noninterest-bearing deposits comprised 20.8% of total deposits for the first quarter in 2000, compared to 20.6% for the prior quarter. 18 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Certain client service expenses were incurred by the Company with respect to its noninterest-bearing liabilities. These expenses include messenger services, check supplies and other related items and are included in operating expenses. Had they been included in interest expense, the impact of these expenses on the Company's net yield on interest-earning assets would have been as follows for each of the quarters presented. Three Months Ended March 31, ----------------------------------------- (Dollars in thousands) 2000 1999 - ---------------------------------------------------------------------------------------------------------------------------- Average noninterest bearing demand deposits $ 559,727 $ 364,366 Client service expenses 500 439 Client service expenses, annualized 0.36% 0.49% IMPACT ON NET YIELD ON INTEREST-EARNING ASSETS: Net yield on interest-earning assets 5.16% 5.00% Impact of client service expense (0.07)% (0.09)% ----------------------------------------- Adjusted net yield on interest-earning assets (1) 5.09% 4.91% ========================================= (1) Noninterest-bearing liabilities are included in cost of funds calculations to determine adjusted net yield of spread. The impact on the net yield on interest-earning assets is determined by offsetting net interest income by the cost of client service expense, which reduces the yield on interest-earning assets. The cost for client service expense reflects the Company's efforts to control its interest expense. Provision for Loan Losses The provision for loan losses represents the current period credit cost associated with maintaining an appropriate allowance for credit losses. The loan loss provision for each period is dependent upon many factors, including loan growth, net charge-offs, changes in the composition of the loan portfolio, delinquencies, management's assessment of the quality of the loan portfolio, the value of the underlying collateral on problem loans and the general economic conditions in the Company's market area. Periodic fluctuations in the provision for loan losses result from management's assessment of the adequacy of the allowance for loan losses; however, actual loan losses may vary from current estimates. Refer to the section "FINANCIAL CONDITION - Allowance for Loan Losses" for a description of the methodology the Company uses in determining an adequate allowance for loan losses. The provision for loan losses for the first quarter of 2000 was $5.2 million, compared to $1.2 million for the first quarter of 1999. In addition, in connection with the MD Bancshares merger, the Company made an additional provision for loan losses of $850,000 in the first quarter of 2000 to conform to the Company's allowance methodology. Nonperforming loans, comprised of nonaccrual loans, restructured loans, and accruing loans past due 90 days or more, increased from $4.1 million, or 0.27% of loans outstanding, at March 31, 1999, to $5.9 million or 0.28% of loans outstanding at March 31, 2000. 19 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) For further information on nonperforming and classified loans and the allowance for loan losses, see--"Nonperforming and Classified Assets" herein. Other Income Total other income increased to $14.7 million for the first quarter of 2000 compared to $3.1 million for the first quarter of 1999. The following table sets forth information by category of other income for the quarters indicated. At and for the three month periods ended ------------------------------------------------------------------------------ March 31, December 31, September 30, June 30, March 31, (Dollars in thousands) 2000 1999 1999 1999 1999 - --------------------------------------------------------------------------------------------------------------------------- Loan and international banking fees $ 991 862 871 651 449 Trust fees 924 774 768 727 721 Service charges and other fees 811 916 791 660 712 ATM network revenue 425 474 620 501 515 Gain on sale of SBA loans 108 85 272 351 302 Gain (loss) on sale of investments, net (1) (23) 4 - - Other 2,827 3,949 1,836 591 419 ------------------------------------------------------------------------------ Total, recurring 6,085 7,037 5,162 3,481 3,118 Warrant income 8,609 14,278 - 226 4 ------------------------------------------------------------------------------ Total $ 14,694 $ 21,315 $ 5,162 $ 3,707 $ 3,122 ============================================================================== 20 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) For the first quarter of 2000 as compared to the same period in 1999, the increase in other income was a result of $542,000 increase in loan and international banking fees, a $99,000 increase in service charges and other fees, and a $203,000 increase in trust fees. These increases were a result of significant growth in total loans, total deposits and trust assets. The gains on sale of SBA loans has declined to $108,000 as compared to $302,000 for the same quarter in 1999. The average premiums paid on SBA loans sold has declined reducing the gains earned by the Company. Other income for the first quarter of 2000 includes $2.1 million in appreciation recognized on equity securities received in the settlement of a loan. As discussed further below, the warrant income resulted from the sale of stock acquired from clients in connection with financing activities. In November 1999, the voters of San Francisco adopted an ordinance which prohibits financial institutions in San Francisco from imposing surcharges of any kind to noncustomers who access automated teller machines to conduct electronic transactions, including cash withdrawals and fund transfers. Other cities in California have either adopted or are considering similar proposals. The Company estimates that approximately $37,000 of ATM network revenue during the first quarter of 2000 was derived from such type of surcharges in the City and County of San Francisco. While the implementation of this ordinance has been blocked through legal challenges and is not material, the adoption of similar laws in other areas where the Company operates ATMs could cause a more substantial reduction in ATM network revenue in the future. Other income for the first quarter of 2000 and the first quarter of 1999 included warrant income of $8.6 million and $4,000, respectively, net of related employee incentives. The Company holds in excess of 100 warrant positions. We have historically obtained rights to acquire stock, in the form of warrants, in certain clients as part of negotiated credit facilities. We may not be able to realize gains form these equity instruments in future periods due to fluctuations in the market prices of the underlying common stock of these companies. The timing and amount of income, if any, from the disposition of client warrants typically depend upon factors beyond our control, including the general condition of the public equity markets, levels of mergers and acquisitions activity, and legal and contractual restrictions on our ability to sell the underlying securities. Therefore, future gains cannot be predicted with any degree of accuracy and are likely to vary materially from period to period. In addition, a significant portion of the income we realize from the disposition of client warrants may be offset by expenses related to our efforts to build an infrastructure sufficient to support our present and future business activities, as well as expenses incurred in evaluating and pursuing new business opportunities, or by increases to the provision for loan losses. Operating Expenses The following table sets forth the major components of operating expenses for the quarters indicated. At and for the three month periods ended March 31, December 31, ------------------------------------------- (Dollars in thousands) 2000 1999 - ----------------------------------------------------------------------------------------------------------------------- Compensation and benefits $ 10,979 $ 10,745 Occupancy and equipment 3,917 3,449 Legal and other professional fees 806 481 Telephone, postage and supplies 720 750 Marketing and promotion 564 556 Client services 500 474 FDIC insurance and regulatory assessments 202 179 Directors' fees 109 357 Expenses on other real estate owned 10 (53) Other 1,528 1,449 ------------------------------------------- Total operating expenses, excluding merger costs 19,335 18,387 Contribution to the GBB Foundation and related expense, net - 11,837 Merger costs 3,881 6,367 ------------------------------------------- Total operating expenses $ 23,216 $ 36,591 =============================================== Efficiency ratio, excluding trust operations 45.05% 67.20% Efficiency ratio, excluding trust operations and before merger costs 37.30% 33.17% Total operating expenses to average assets* 3.06% 5.16% Total operating expenses to average assets, before merger costs* 2.55% 2.60% At and for the three month periods ended September 30, June 30, March 31, ----------------------------------------------- (Dollars in thousands) 1999 1999 1999 - --------------------------------------------------------------------------------------------------------------------------- Compensation and benefits $ 9,482 $ 9,129 $ 8,714 Occupancy and equipment 2,978 2,750 3,026 Legal and other professional fees 756 601 580 Telephone, postage and supplies 731 703 718 Marketing and promotion 450 457 462 Client services 323 138 439 FDIC insurance and regulatory assessments 167 128 117 Directors' fees 174 52 209 Expenses on other real estate owned 30 15 21 Other 1,889 2,191 1,148 ----------------------------------------------- Total operating expenses, excluding merger costs 16,980 16,164 15,434 Contribution to the GBB Foundation and related expense, net - 323 - Merger costs - 3,965 - ----------------------------------------------- Total operating expenses $ 16,980 $ 20,452 $ 15,434 =============================================== Efficiency ratio, excluding trust operations 47.98% 66.14% 55.41% Efficiency ratio, excluding trust operations and before merger costs 47.98% 59.10% 55.41% Total operating expenses to average assets* 2.66% 3.43% 2.93% Total operating expenses to average assets, before merger costs* 2.66% 2.71% 2.93% *Annualized 21 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Operating expenses totaled $23.2 million for the first quarter of 2000, compared to $15.4 million for the first quarter of 1999. The ratio of operating expenses to average assets, before merger costs, was 2.55% for the first quarter of 2000 and 2.93% for the first quarter of 1999. The efficiency ratio is computed by dividing total operating expenses by net interest income and other income. An increase in the efficiency ratio indicates that more resources are being utilized to generate the same (or greater) volume of income while a decrease would indicate a more efficient allocation of resources. The Company's efficiency ratio, excluding trust operations and nonrecurring items, for the first quarter of 2000 was 37.30%, compared to 55.41% for the first quarter of 1999. The Company's efficiency ratio for the first quarter of 2000 was lowered in part by the impact of the $2.1 million in appreciation on equity securities received in settlement of a loan. Excluding this income, the Company's efficiency ratio would have been 45.04%. As indicated by the improvements in the efficiency ratio and ratio of total operating expenses to average assets, the Company has been able to achieve increasing economies of scale. For the first quarter of 2000, average assets increased 42.7% from the first quarter of 1999, while operating expenses, excluding nonrecurring cost, increased only 25.3%. Compensation and benefits expenses increased for the first quarter of 2000 to $11.0 million, compared to $8.7 million for the first quarter of 1999. The increase in compensation and benefits is due primarily to the addition of personnel to accommodate the growth of the Company. The increase in occupancy and equipment; telephone, postage, and supplies; marketing and promotion; and client service expense was related to the Company's growth. Income Taxes The Company's effective income tax rate for the first quarter of 2000 was 40.5%, compared to 38.9% in the first quarter of 1999. The effective rates were lower than the statutory rate of 42.0% due to tax-exempt income on municipal securities, state enterprise zone credits and the preferential tax treatment of the donation of appreciated warrants to the Foundation. The reductions were partially offset by the impact of merger and other related nonrecurring costs. FINANCIAL CONDITION Total assets increased 12.4% to $3.2 billion at March 31, 2000, compared to $2.8 billion at December 31, 1999. The increase in the first quarter of 2000 was primarily due to increases in the Company's loan portfolio funded by growth in deposits. Loans Total gross loans increased 8.4% (33.7% annualized) to $2.1 billion at March 31, 2000, compared to $1.9 billion at December 31, 1999. The increase in the loan volume during the first three months of 2000 was primarily due to the continued strength of the economy in the Company's market areas coupled with the business development efforts of the Company's relationship managers. 22 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The Company's loan portfolio is concentrated in commercial (primarily manufacturing, service and technology) and real estate lending, with the balance in consumer loans. While no specific industry concentration is considered significant, the Company's lending operations are located in a market area that is dependent on the technology and real estate industries and supporting service companies. Thus, the Company's borrowers could be adversely impacted by a downturn in these sectors of the economy. This could, in turn, reduce the demand for loans and adversely impact the borrowers' abilities to repay their loans, while also decreasing the Company's net interest margin. The following table presents the composition of the Company's loan portfolio at the dates indicated. March 31, December 31, 2000 1999 ------------------------------------------------------ (Dollars in thousands) Amount % Amount % - -------------------------------------------------------------------------------------------------------- Commercial $ 917,326 45.0% $ 810,399 43.1% Term real estate - Commercial 522,852 25.7 484,076 25.7 ------------------------------------------------------ Total commercial 1,440,178 70.7 1,294,475 68.8 Real estate construction and land 441,085 21.6 417,326 22.2 Real estate term - other 97,437 4.8 92,688 4.9 Consumer and other 111,269 5.5 123,528 6.6 ------------------------------------------------------ Total loans, gross 2,089,969 102.6 1,928,017 102.5 Deferred fees and discounts, net (7,321) (0.4) (6,840) (0.4) ------------------------------------------------------ Total loans, net of deferred fees 2,082,648 102.2 1,921,177 102.1 Allowance for loan losses (44,820) (2.2) (40,421) (2.1) ------------------------------------------------------ Total loans, net $ 2,037,828 100.0% $ 1,880,756 100.0% ====================================================== March 31, 1999 ---------------------------- Amount % ---------------------------- Commercial $ 651,860 44.7% Term real estate - Commercial 369,663 25.4 ---------------------------- Total commercial 1,021,523 70.1 Real estate construction and land 272,300 18.7 Real estate term - other 90,417 6.2 Consumer and other 105,329 7.2 ---------------------------- Total loans, gross 1,489,569 102.2 Deferred fees and discounts, net (5,598) (0.4) ---------------------------- Total loans, net of deferred fees 1,483,971 101.8 Allowance for loan losses (26,866) (1.8) ---------------------------- Total loans, net $ 1,457,105 100.0% ============================ Nonperforming and Classified Assets Management generally places loans on nonaccrual status when they become 90 days past due, unless they are well secured and in the process of collection. When a loan is placed on nonaccrual status, any interest previously accrued but not collected is generally reversed from income. Loans are charged off when management determines that collection has become unlikely. Restructured loans are those where the Banks have granted a concession on the interest paid or original repayment terms due to financial difficulties of the borrower. Other real estate owned ("OREO") consists of real property acquired through foreclosure on the related collateral underlying defaulted loans. 23 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The following table sets forth information regarding nonperforming assets at the dates indicated. At and for the three month periods ended March 31, December 31, September 30, June 30, March 31, --------------------------------------------------------------------------- (Dollars in thousands) 2000 1999 1999 1999 1999 - ----------------------------------------------------------------------------------------------------------------------------------- Nonperforming loans Nonaccrual loans $ 5,170 $ 4,418 $ 6,028 $3,487 $ 3,104 Accruing loans past due 90 days or more 10 51 - 199 - Restructured loans 743 807 1,492 1,034 951 ------------------------------------------------------------- Total nonperforming loans 5,923 5,276 7,520 4,720 4,055 Other real estate owned 271 271 515 595 620 ------------------------------------------------------------- Total nonperforming assets $ 6,194 $ 5,547 $ 8,035 $5,315 $ 4,675 ------------------------------------------------------------- Nonperforming assets to total loans and other real estate owned 0.30% 0.29% 0.46% 0.33% 0.31% Nonperforming assets to total assets 0.19% 0.19% 0.30% 0.22% 0.21% At March 31, 2000, the Company had $5.2 million in nonaccrual loans. Interest income foregone on nonaccrual loans outstanding totaled $241,000 and $64,000 for the three months ended March 31, 2000 and 1999, respectively. The Company records OREO at the lower of carrying value or fair value less estimated costs to sell. Estimated losses that result from the ongoing periodic valuation of these properties are charged to earnings through a provision for losses on foreclosed property in the period in which they are identified. At March 31, 2000, OREO acquired through foreclosure had a carrying value of $271,000, same as December 31, 1999. The Company had $743,000 and $807,000 of restructured loans as of March 31, 2000 and December 31, 1999, respectively. There were no principal reduction concessions allowed on restructured loans during the first quarter of 2000 or 1999. Interest income from restructured loans totaled $20,000 and $9,000 for the three months ended March 31, 2000 and 1999, respectively. Foregone interest income, which totaled $241,000 and $8,000 for the three months ended March 31, 2000 and 1999, respectively, would have been recorded as interest income if the loans had accrued interest in accordance with their original terms prior to the restructurings. The Company has three classifications for problem loans: "substandard," "doubtful" and "loss." Substandard loans have one or more defined weaknesses and are characterized by the distinct possibility that the Banks will sustain some loss if the deficiencies are not corrected. Doubtful loans have the weaknesses of substandard loans with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable; and there is a high possibility of loss of some portion of the principal balance. A loan classified as "loss" is considered uncollectible and its continuance as an asset is not warranted. 24 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The following table sets forth the classified assets at the dates indicated. At and for the three month periods ended March 31, December 31, September 30, June 30, March 31, ---------------------------------------------------------------------------- (Dollars in thousands) 2000 1999 1999 1999 1999 - ------------------------------------------------------------------------------------------------------------------------------------ Substandard $ 24,398 $ 23,431 $ 25,390 $23,150 $ 16,296 Doubtful 4,739 1,850 2,134 1,139 1,026 Loss - - - - - Other real estate owned 271 271 515 595 620 ---------------------------------------------------------------------------- Classified assets $ 29,408 $ 25,552 $ 28,039 $24,884 $ 17,942 ============================================================================ Classified assets to total loans and other real 1.41% 1.33% 1.61% 1.55% 1.21% estate owned Allowance for loan losses to total classified assets 152.41% 158.19% 117.79% 117.29% 149.74% With the exception of these classified assets, management was not aware of any loans outstanding as of March 31, 2000 where the known credit problems of the borrower would cause management to have serious doubts as to the ability of such borrowers to comply with their present loan repayment terms and which would result in such loans being included in nonperforming or classified asset tables at some future date. Management cannot, however, predict the extent to which economic conditions in the Company's market areas may worsen or the full impact that such an environment may have on the Company's loan portfolio. Accordingly, there can be no assurance that other loans will not become 90 days or more past due, be placed on nonaccrual, become restructured loans, or other real estate owned in the future. Allowance For Loan Losses The allowance for loan losses is established through a provision for loan losses based on management's evaluation of risk inherent in the Company's loan portfolio. The allowance is increased by provisions charged against earnings and reduced by net loan charge-offs. Loans are charged-off when they are deemed to be uncollectible; recoveries are generally recorded only when cash payments are received. 25 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) The following table sets forth information concerning the Company's allowance for loan losses at the dates and for the quarters indicated. At and for the three month periods ended March 31, December 31, September 30, ------------------------------------------------- (Dollars in thousands) 2000 1999 1999 - ----------------------------------------------------------------------------------------------------------- Period end loans outstanding $ 2,082,648 $ 1,921,177 $ 1,743,531 Average loans outstanding $ 1,985,551 $ 1,814,744 $ 1,675,088 Allowance for loan losses: Balance at beginning of period $ 40,421 $ 33,028 $ 29,187 Charge-offs: Commercial (1,686) (1,331) (601) Real estate construction and land -- -- -- Real estate term -- -- -- Consumer and other (97) (80) (103) ------------------------------------------- Total charge-offs (1,783) (1,411) (704) ------------------------------------------- Recoveries: Commercial 102 -- 748 Real estate construction and land -- -- -- Real estate term -- -- -- Consumer and other 3 277 42 ------------------------------------------- Total recoveries 105 277 790 ------------------------------------------- Net charge-offs (1,678) (1,134) 86 Provision charged to income (1) 6,077 8,527 3,755 ------------------------------------------- Balance at end of period $ 44,820 $ 40,421 $ 33,028 =========================================== Quarterly net charge-offs to average loans outstanding during the period, annualized 0.34% 0.28% -0.02% Year to date net charge-offs to average loans outstanding during the period, annualized 0.34% 0.09% 0.02% Allowance as a percentage of average loans outstanding 2.26% 2.23% 1.97% Allowance as a percentage of period end loans outstanding 2.15% 2.10% 1.89% Allowance as a percentage of non-performing loans 756.71% 766.13% 439.20% June 30, March 31, ---------------------------- 1999 1999 ---------------------------- Period end loans outstanding $ 1,600,326 $ 1,483,971 Average loans outstanding $ 1,548,566 $ 1,403,292 Allowance for loan losses: Balance at beginning of period $ 26,866 $ 25,960 Charge-offs: Commercial (200) (226) Real estate construction and land -- -- Real estate term -- -- Consumer and other (43) (69) ---------------------------- Total charge-offs (243) (295) ---------------------------- Recoveries: Commercial 195 21 Real estate construction and land -- -- Real estate term 1 -- Consumer and other 5 17 ---------------------------- Total recoveries 201 38 ---------------------------- Net charge-offs (42) (257) Provision charged to income (1) 2,363 1,163 ---------------------------- Balance at end of period $ 29,187 $ 26,866 ============================ Quarterly net charge-offs to average loans outstanding during the period, annualized 0.01% 0.07% Year to date net charge-offs to average loans outstanding during the period, annualized 0.04% 0.07% Allowance as a percentage of average loans outstanding 1.88% 1.91% Allowance as a percentage of period end loans outstanding 1.82% 1.81% Allowance as a percentage of non-performing loans 618.37% 662.54% - ----------------------- (1) Includes $850,000 in the first quarter of 2000, $2,300,000 in the fourth quarter of 1999 and $400,000 in the second quarter of 1999 to conform practices to the Company's reserve methodologies, which is included in mergers and related nonrecurring costs. The Company employs a systematic methodology for determining its allowance for loan losses, which includes a monthly review process and monthly adjustment of the allowance. The Company's process includes a periodic loan by loan review for loans that are individually evaluated for impairment as well as detailed reviews of other loans (either individually or in pools). This includes an assessment of known problem loans, potential problem loans, and other loans that exhibit indicators of deterioration. The Company's methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan losses that management believes is appropriate at each reporting date. Quantitative factors include the Company's historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans, and other factors. Quantitative factors also incorporate known information about individual loans including borrowers' sensitivity to interest rate movements and borrowers' sensitivity to quantifiable external factors including commodity and finished goods prices as well as acts of nature (earthquakes, fires, etc.) that occur in a particular period. 26 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Qualitative factors include the general economic environment in the Company's marketplace, and in particular, the state of the technology industries based in the Silicon Valley and other key industries in the San Francisco Bay Area. Size and complexity of individual credits in relation to lending officers' background and experience levels, loan structure, extent and nature of waivers of existing loan policies and pace of portfolio growth are other qualitative factors that are considered in the Company's methodology. The Company's methodology is, and has been, consistently followed. However, as the Company adds new products, increases in complexity, and expands its geographic coverage, the Company intends to enhance its methodology to keep pace with the size and complexity of the loan portfolio. In this regard, the Company has periodically engaged outside firms to independently assess the Company's methodology, and on an ongoing basis the Company engages outside firms to perform independent credit reviews of its loan portfolio. Management believes that the Company's systematic methodology continues to be appropriate given the Company's size and level of complexity. While this methodology utilizes historical and other objective information, the establishment of the allowance for loan losses and the classification of loans, is to some extent, based on the judgment and experience of management. In general, management feels that the allowance for loan losses is adequate as of March 31, 2000. However, future changes in circumstances, economic conditions or other factors could cause management to increase or decrease the allowance for loan losses as necessary. At March 31, 2000, the allowance for loan losses was $44.8 million, consisting of a $30.8 million allocated allowance and a $14.0 million unallocated allowance. The unallocated allowance recognizes the model and estimation risk associated with the allocated allowances, and management's evaluation of various conditions, the effects of which are not directly measured in determining the allocated allowance. The evaluation of the inherent loss regarding these conditions involves a higher degree of uncertainty because they are not identified with specific problem credits or portfolio segments. The conditions evaluated in connection with the unallocated allowance include the following at the balance sheet date: . The strength and duration of the current business cycle and existing general economic and business conditions affecting our key lending areas; economic and business conditions affecting our key lending portfolios; . Seasoning of the loan portfolio, growth in loan volumes and changes in loan terms; and . The results of bank regulatory examinations. 27 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) Liquidity and Cash Flow The objective of liquidity management is to maintain each Bank's ability to meet the day-to-day cash flow requirements of its clients who either wish to withdraw funds or require funds to meet their credit needs. The Company must manage its liquidity position to allow the Banks to meet the needs of their clients while maintaining an appropriate balance between assets and liabilities to meet the return on investment expectations of its shareholders. The Company monitors the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and repayments and maturities of loans and investments, the Banks utilize brokered deposit lines, sell securities under agreements to repurchase and borrow overnight federal funds. Greater Bay is a company separate and apart from the Banks. It must provide for its own liquidity. Substantially all of Greater Bay's revenues are obtained from management fees, interest received on its investments and dividends declared and paid by the Banks. There are statutory and regulatory provisions that could limit the ability of the Banks to pay dividends to Greater Bay. At March 31, 2000, the Banks had approximately $53.9 million in the aggregate available to be paid as dividends to Greater Bay. Management of Greater Bay believes that such restrictions will not have an impact on the ability of Greater Bay to meet its ongoing cash obligations. As of March 31, 2000, Greater Bay did not have any material commitments for capital expenditures. Net cash provided by operating activities, consisting primarily of net income and increases in interest payable and other liabilities, totaled $9.4 million and $11.7 million for the three months ended March 31, 2000 and 1999, respectively. Cash used for investing activities totaled $256.8 million and $171.9 million for the three months ended March 31, 2000 and 1999, respectivley. The funds used for investing activities primarily represent increases in loans and investment securities for each year reported. For the three months ended March 31, 2000 net cash provided by financing activities was $333.1 million, compared to $211.8 million for the three months ended March 31, 2000. Historically, the primary financing activity of the Company has been through deposits. For the three months ended March 31, 2000 and 1999, deposit gathering activities generated cash of $339.1 million and $225.5 million, respectively. This represents a total of 101.8% and 106.5% of the financing cash flows for the three months ended March 31, 2000 and 1999, respectively. The Company has supplemented its financing activities through the issuance of Trust Preferred Securities and common stock. See "Capital Resources" for further discussion below. Capital Resources Shareholders' equity at March 31, 2000 increased to $198.4 million from $173.4 million at December 31, 1999. Greater Bay paid dividends of $0.15 and $0.48 per share during the three months ended March 31, 2000 and the twelve months ended December 31, 1999, respectively, excluding dividends paid by subsidiaries prior to the completion of their mergers. In the first quarter of 2000 and the fourth quarter of 1999 the Company issued 324,324 and 535,000 shares of common stock in a private placement, respectively. The proceeds from the offering were $11.5 million and $19.0 million, respectively, net of issuance costs. Greater Bay used a portion of the net proceeds from the offering to supplement the capital of the Banks and intends to use the remainder for general corporate purposes. 28 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (CONTINUED) In 1997, the Company issued $20.0 million in TPS to enhance its regulatory capital base, while also providing added liquidity. In 1998, the Company completed a second offering of TPS in an aggregate amount of $30.0 million. In the first quarter of 2000, the Company completed a third offering of TPS in an aggregate amount of $9.5 million. Under applicable regulatory guidelines, the TPS qualifies as Tier I capital up to a maximum of 25% of Tier I capital. Any additional portion of TPS would qualify as Tier 2 capital. As of March 31, 2000, $59.5 million of the TPS qualified as Tier I capital. As the Company's shareholders' equity increases, the amount of Tier I capital that can be comprised of TPS will increase. The Company is committed to remaining well-capitalized as defined by regulatory guidelines. If deposit and loan growth continues at current levels, it is anticipated the Company will need to raise additional capital to remain well-capitalized in 2000. The Company is evaluating an additional issuance of TPS as well as other alternatives to meet this anticipated increase in required capital. We anticipate that we will be able to leverage any further issuance of TPS and therefore we do not anticipate that the raising of additional TPS would be dilutive to future net income per share. However, the impact of raising any additional capital on net income per share will depend on the type of capital raised, the terms of the capital, the time period required to invest the capital funds into earning-assets and the type of assets funded. A banking organization's total qualifying capital includes two components, core capital (Tier 1 capital) and supplementary capital (Tier 2 capital). Core capital, which must comprise at least half of total capital, includes common shareholders' equity, qualifying perpetual preferred stock, trust preferred securities and minority interests, less goodwill. Supplementary capital includes the allowance for loan losses (subject to certain limitations), other perpetual preferred stock, trust preferred securities, certain other capital instruments and term subordinated debt. The Company's major capital components are shareholders' equity and TPS in core capital, and the allowance for loan losses in supplementary capital. At March 31, 2000, the minimum risk-based capital requirements to be considered adequately capitalized were 4.0% for core capital and 8.0% for total capital. Federal banking regulators have also adopted leverage capital guidelines to supplement risk-based measures. The leverage ratio is determined by dividing Tier 1 capital as defined under the risk-based guidelines by average total assets (not risk-adjusted) for the preceding quarter. Pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991, the Federal Reserve, the OCC and the FDIC have adopted regulations setting forth a five-tier system for measuring the capital adequacy of the financial institutions they supervise. The capital levels of the Company at March 31, 2000 and the two highest levels recognized under these regulations are as follows. These ratios all exceeded the well-capitalized guidelines shown below. Tier 1 Total Leverage Risk-Based Risk-Based Ratio Capital Ratio Capital Ratio ----- ------------- ------------- Company 8.86% 10.10% 11.48% Well-capitalized 5.00% 6.00% 10.00% Adequately capitalized 4.00% 4.00% 8.00% In addition, at March 31, 2000, each of the Banks had levels of capital that exceeded the well-capitalized guidelines. 29 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's financial performance is impacted by, among other factors, interest rate risk and credit risk. The Company utilizes no derivatives to mitigate its credit risk, relying instead on loan review and an adequate loan loss reserve (see "--Allowance for Loan Losses" herein). Interest rate risk is the risk of loss in value due to changes in interest rates. This risk is addressed by the Company's Asset Liability Management Committee ("ALCO"), which includes senior management representatives. The ALCO monitors and considers methods of managing interest rate risk by monitoring changes in net portfolio values and net interest income under various interest rate scenarios. The ALCO attempts to manage the various components of the Company's balance sheet to minimize the impact of sudden and sustained changes in interest rates on net portfolio value and net interest income. The Company's exposure to interest rate risk is reviewed on at least a quarterly basis by the Board of Directors and the ALCO. Interest rate risk exposure is measured using interest rate sensitivity analysis to determine the Company's change in net portfolio value in the event of hypothetical changes in interest rates and interest liabilities. If potential changes to net portfolio value and net interest income resulting from hypothetical interest rate swings are not within the limits established by the Board, the Board may direct management to adjust its asset and liability mix to bring interest rate risk within Board-approved limits. In order to reduce the exposure to interest rate fluctuations, the Company has developed strategies to manage its liquidity, lengthen the effective maturities of certain interest-earning assets, and shorten the effective maturities of certain interest-bearing liabilities. The Company has focused its investment activities on securities with generally medium-term (8 years to 12 years) maturities or average lives. The Company has utilized short-term borrowings and deposit marketing programs to adjust the term to repricing of its liabilities. In addition, the Company has utilized an interest rate swap to manage the interest rate risk of the TPS II securities. This interest rate swap is not an "ineffective hedge" and is accounted for under Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities". Interest rate sensitivity analysis is used to measure the Company's interest rate risk by computing estimated changes in net portfolio value of its cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. Net portfolio value represents the market value of portfolio equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for off- balance sheet items. This analysis assesses the risk of loss in market rate sensitive instruments in the event of sudden and sustained increases and decreases in market interest rates of 100 basis points. The following table presents the Company's projected change in net portfolio value for these rate shock levels as of March 31, 2000. All market rate sensitive instruments presented in this table are classified as either held to maturity or available for sale. The Company has no trading securities. (Dollars in thousands) Projected Change Change in ---------------------------- Interest Rates Net Porfolio Value Dollars Percentage - --------------------------------------------------------------------------------------- 100 basis point rise $ 529,853 $ 6,777 1.30% Base scenario 523,077 - - 100 basis point decline 515,499 (7,577) -1.45% 30 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (CONTINUED) The preceding table indicates that at March 31, 2000, in the event of a sudden and sustained decrease in prevailing market interest rates, the Company's net portfolio value would be expected to increase. However, the foregoing analysis does not attribute additional value to the Company's noninterest- bearing deposit balances, which have a significantly higher market value during periods of increasing interest rates. Net portfolio value is calculated based on the net present value of estimated cash flows utilizing market prepayment assumptions and market rates of interest provided by independent broker quotations and other public sources. Computation of forecasted effects of hypothetical interest rate changes is based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay, and should not be relied upon as indicative of actual future results. Further, the computations do not contemplate any actions the ALCO could undertake in response to changes in interest rates. Certain shortcomings are inherent in the method of analysis presented in the computation of net portfolio value. Actual values may differ from those projections presented should market conditions vary from assumptions used in the calculation of the net portfolio value. Certain assets, such as adjustable-rate loans, which represent one of the Company's loan products, have features which restrict changes in interest rate on a short-term basis and over the life of the assets. In addition, the proportion of adjustable-rate loans in the Company's portfolio could decrease in future periods if market interest rates remain at or decrease below current levels due to refinancing activity. Further, in the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in the net portfolio value. Finally, the ability of many borrowers to repay their adjustable-rate mortgage loans may decrease in the event of significant interest rate increases. Interest Rate Risk Management Interest rate risk management is a function of the repricing characteristics of the Company's portfolio of assets and liabilities. Interest rate risk management focuses on the maturity structure of assets and liabilities and their repricing characteristics during periods of changes in market interest rates. Effective interest rate risk management seeks to ensure that both assets and liabilities respond to changes in interest rates within an acceptable time frame, thereby minimizing the effect of interest rate movements on net interest income. Interest rate sensitivity is measured as the difference between the volumes of assets and liabilities in the Company's current portfolio that are subject to repricing at various time horizons: one day or immediate, two days to six months, seven to twelve months, one to three years, four to five years, over five years and on a cumulative basis. The differences are known as interest sensitivity gaps. 31 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (CONTINUED) The following table shows interest sensitivity gaps for different intervals as of March 31, 2000. Immediate or 2 Days to 7 Months to 1 Year to 3 4 Years to One Day 6 Months 12 Months Years 5 Years ---------------------------------------------------------------- Assets (Dollars in thousands) Cash and Due $ 1,475 $ -- $ -- $ -- $ -- Federal Funds Sold 285,105 -- -- -- -- Investment Securities -- 25,247 19,019 118,298 74,862 Loans 1,004,262 538,509 79,603 155,459 139,875 Allowance for Loan Losses/Unearned Fees -- -- -- -- -- Other Assets -- -- -- -- -- -------------------------------------------------------------- Total Assets $1,290,842 $ 563,756 $ 98,622 $ 273,757 $ 214,737 ============================================================== Liabilities and Equity Deposits $2,295,306 $ 472,150 $ 65,566 $ 10,912 $ 1,366 Other Borrowings 14,100 25,000 -- -- 2,000 Trust Preferred Securities -- -- -- -- -- Other Liabilities -- -- -- -- -- Shareholders Equity -- -- -- -- -- -------------------------------------------------------------- Total Liab/Equity $2,309,406 $ 497,150 $ 65,566 $ 10,912 $ 3,366 ============================================================== Gap $(1,018,564) $ 66,606 $ 33,056 $ 264,845 $ 211,371 Cumulative Gap $(1,018,564) $(951,958) $(918,902) $(656,057) $(444,687) Cumulative Gap/Total Assets -31.9% -29.8% -28.7% -20.5% -13.9% More than 5 Total Rate Non-Rate Years Sensitive Sensitive Total ------------------------------------------------- Assets Cash and Due $ -- $ 1,475 $ 137,462 $ 138,937 Federal Funds Sold -- 285,105 -- 285,105 Investment Securities 361,207 598,633 (13,474) 585,159 Loans 164,449 2,082,156 492 2,082,648 Allowance for Loan Losses/Unearned Fees -- -- (44,820) (44,820) Other Assets -- -- 150,612 150,612 ------------------------------------------------- Total Assets $ 525,656 $2,967,369 $ 230,273 $3,197,642 ================================================= Liabilities and Equity Deposits $ 166 $2,845,466 $ -- $2,845,466 Other Borrowings -- 41,100 -- 41,100 Trust Preferred Securities 59,500 59,500 -- 59,500 Other Liabilities -- -- 53,226 53,226 Shareholders Equity -- -- 198,350 198,350 ------------------------------------------------- Total Liab/Equity $ 59,666 $2,946,066 $ 251,576 $3,197,642 ================================================= Gap $ 465,990 $ 21,303 $ (21,303) $ -- Cumulative Gap $ 21,303 $ 21,303 $ -- $ -- Cumulative Gap/Total Assets 0.7% 0.7% -- -- 32 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (CONTINUED) The foregoing table indicates that the Company had a one year gap of $918.9 million, or 28.7% of total assets, at March 31, 2000. In theory, this would indicate that at March 31, 2000, $918.9 million more in liabilities than assets would reprice if there was a change in interest rates over the next year. Thus, if interest rates were to increase, the gap would tend to result in a higher net interest margin. Conversely, if interest rates decreased, the gap may result in decreases net interest margin. However, changes in the mix of earning assets or supporting liabilities can either increase or decrease the net interest margin without affecting interest rate sensitivity. In addition, the interest rate spread between an asset and its supporting liability can vary significantly while the timing of repricing of both the asset and its supporting liability can remain the same, thus impacting net interest income. This characteristic is referred to as basis risk and, generally, relates to the repricing characteristics of short-term funding sources such as certificates of deposit. The impact of fluctuations in interest rates on the Company's projected next twelve month net interest income and net income has been evaluated through an interest rate shock simulation modeling analysis that includes various assumptions regarding the repricing relationship of assets and liabilities, as well as the anticipated changes in loan and deposit volumes over differing rate environments. As of March 31, 2000,the analysis indicates that the Company's net interest income would increase a maximum of 11.64% if rates rose 200 basis points immediately and would decrease a maximum of 11.27% if rates declined 200 basis points immediately. In addition, the results indicate that notwithstanding the Company's gap position, which would indicate that the net interest margin increases when rates rise, the Company's net interest margin increases during rising rate periods due to the basis risk imbedded in the Company's interest- bearing liabilities. The Company has revised the assumptions used in performing this analysis following a detailed review of its ALCO pricing history. As a result, the anticipated impact of interest rate changes on the Company's net interest income has increased since December 31, 1998. In addition, while this analysis indicates the probable impact of interest rate movements on the Company's net interest income, it does not take into consideration other factors that would impact this analysis. These factors would include management's and ALCO's actions to mitigate the impact to the Company and the impact of the Company's credit risk profile during periods of significant interest rate movements. Varying interest rate environments can create unexpected changes in prepayment levels of assets and liabilities which are not reflected in the interest sensitivity analysis table. These prepayments may have significant effects on the Company's net interest margin. Because of these factors and others, an interest sensitivity gap report may not provide a complete assessment of the Company's exposure to changes in interest rates. Year 2000 State of Readiness The Company's mission critical systems successfully responded to the century date change. Accordingly, the Company's core banking systems, including the application software for its deposit, loan and trust computer systems, as well as the electronic funds transfers system with the Federal Reserve, were fully operational and accurately processing customer information and transactions. During 2000, the Company will continue to monitor its systems and those of its major vendors, suppliers and clients to ensure continued compliance. 33 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK (CONTINUED) Recent Accounting Developments In April 1999, the Financial Accounting Standards Board ("FASB") reached tentative conclusions on the future of the pooling-of-interests method of accounting for business combinations. These tentative decisions include the decision that the pooling-of-interests method of accounting will no longer be an acceptable method to account for business combinations between independent parties and that there should be a single method of accounting for all business combinations, and that method is the purchase method. The FASB agreed that the purchase method should be applied prospectively to business combination transactions that are initiated after the final standard is issued. The FASB has issued an exposure draft during the third quarter of 1999 and expects a final standard will be issued and become effective in the fourth quarter of 2000. A portion of the Company's business strategy is to pursue acquisition opportunities so as to expand its market presence and maintain growth levels. A change in the accounting for business combinations could have a negative impact on the Company's ability to realize those business strategies. 34 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings -- Not applicable ITEM 2. Changes in Securities and Use of Proceeds - On March 23, 2000, Greater Bay completed a private offering pursuant to Rule 506 under the Securities Act of 1933, as amended, of 324,324 shares of restricted common stock to institutional investors. Keefe, Bruyette, and Woods, Inc. acted as a placement agent for the offering. Proceeds from the offering were $12,000,000, less placement agent fees of $513,000. On April 26, 2000, Greater Bay filed a registration statement on Form S-3 (333-35622) to register the shares for resale, which became effective on May 10, 2000. Greater Bay intends to use the net proceeds from the offering for general corporate purposes. ITEM 3. Defaults Upon Senior Securities -- Not applicable ITEM 4. Submission of Matters to a Vote of Security Holders - Not applicable ITEM 5. Other Information -- Not applicable ITEM 6. Exhibits and Reports on Form 8-K The Exhibits listed below are filed or incorporated by reference as part of this Report. (a) Exhibits EXHIBIT NO. EXHIBITS - ------- -------- 2.1 Agreement and Plan of Reorganization by and between Greater Bay Bancorp and Coast Bancorp dated December 14, 1999 (Incorporated by reference from Greater Bay Bancorp's Current Report on Form 8-K filed with the SEC on December 16, 1999.). 2.2 Agreement and Plan of Reorganization, dated as of January 26, 2000, by and among Greater Bay Bancorp, Bank of Santa Clara and GBB Merger Corp. (incorporated by reference to Exhibit 2 from Registrant's Current Report on Form 8-K dated February 3, 2000). 2.3 Agreement and Plan of Reorganization, dated as of March 21, 2000, by and among Greater Bay Bancorp, Bank of Petaluma and DKSS Corp (incorporated by reference to Exhibit 2 from Registrant's Current Report on Form 8-K dated March 22, 2000). 4.1 Securities Purchase Agreement, dated as of March 22, 2000, by and between Greater Bay Bancorp and the investors identified therein (incorporated by reference to Exhibit 4.1 from Registrant's Current Report on Form 8-K dated March 24, 2000). 4.2 Registration Rights Agreement dated as of March 23, 2000, by and between Greater Bay Bancorp and the investors identified therein (incorporated by reference to Exhibit 4.2 from Registrant's Current Report on Form 8-K dated March 24, 2000). 4.3 Amended and Restated Declaration of Trust of GBB Capital III, dated as of March 23, 2000. 4.4 Indenture, dated as of March 23, 2000, between Greater Bay Bancorp and The Bank of New York, as trustee. 4.5 Guarantee Agreement, dated as of March 23, 2000, by and between Greater Bay Bancorp and The Bank of New York, as trustee. 27.1 Financial Data Schedule. - -------- 35 (b) Reports on Form 8-K During the quarter ended March 31 2000, the Registrant filed the following Current Reports on Form 8-K: (1) Form 8-K dated February 1, 2000 (reporting the completion of the merger with Mt. Diablo Bancshares and containing supplemental consolidated financial statements reflecting the merger with Mt. Diablo Bancshares); (2) Form 8-K dated February 3, 2000 (reporting signing of merger agreement with Bank of Santa Clara); (3) Form 8-K dated February 4, 2000 (containing press release regarding positive results of the year 2000 rollover, year end earnings and the completion of the merger with Mt. Diablo Bancshares); (4) Form 8-K dated March 22, 2000 (reporting the signing of merger agreement with Bank of Petaluma); (5) Form 8-K dated March 24, 2000 (reporting the consummation of a private equity offering and the completion of the issuance of $9,500,000 in Fixed Rate Capital Pass-Through Securities) and (6) Form 8-K dated March 31, 2000 (reporting the Registrant's interim financial data as of February 29, 2000 showing 30 days of post-combination operating results. Upon filing of this interim financial data, the Registrant's supplemental consolidated financial statements included in the Registrant's Current Report on Form 8-K, filed with the SEC on February 1, 2000, became the historical consolidated financial statements of the Registrant.). 36 SIGNATURES IN ACCORDANCE WITH THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED, THE REGISTRANT HAS CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED THEREUNTO DULY AUTHORIZED. GREATER BAY BANCORP (Registrant) By: /s/ Steven C. Smith - ------------------- Steven C. Smith Executive Vice President, Chief Administrative Officer and Chief Financial Officer Date: May 10, 2000 37