FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 /X/ Quarterly Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Quarterly Period Ended MARCH 31, 1998 -------------- or / / Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Transition Period from _____________ to ___________ Commission File Number: 0-27384 ------------- CAPITAL CORP OF THE WEST (Exact name of registrant as specified in its charter) California 77-0405791 (State or other jurisdiction IRS Employer ID Number of incorporation or organization) 550 West Main, Merced, CA 95340 (Address of principal executive offices) Registrant's telephone number, including area code: (209) 725-2200 ------------------- Former name, former address and former fiscal year, if changed since last report: NOT APPLICABLE ---------------- 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 ---- ----- The number of shares outstanding of the registrant's common stock, no par value, as of March 31, 1998 was $4,381,975. No shares of preferred stock, no par value, were outstanding at March 31, 1998. CAPITAL CORP OF THE WEST Table of Contents PART I. -- FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Balance Sheets 3 Consolidated Statements of Income 4 Consolidated Statements of Cash Flows 5 Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 7 PART II. -- OTHER INFORMATION Item 1. Legal Proceedings 25 Item 2. Changes in Securities 25 Item 3. Defaults Upon Senior Securities 25 Item 4. Submission of matters to a vote of Security Holders 25 Item 5. Other Information 25 Item 6. Exhibits and Reports on Form 8-K 25 SIGNATURES 27 2 Capital Corp of the West Consolidated Balance Sheets (Unaudited) 03/31/98 12/31/97 03/31/97 --------- -------- -------- (In thousands) ASSETS Cash & noninterest-bearing deposits in other banks $ 21,626 $ 21,035 $ 17,967 Federal funds sold 44,900 2,400 - Time deposits at other financial institutions 1,000 599 1,288 Investment securities available for sale, at fair value 107,210 135,257 46,046 Investment securities held-to-maturity at cost 9,789 12,775 11,456 Loans, net of allowance for loan losses of $3,799,000 at March 31, 1998; $3,833,000 at December 31, 1997; and $2,674,000 at March 31, 1997 217,309 214,144 185,381 Interest receivable 2,462 2,741 1,985 Premises and equipment, net 13,167 12,945 8,095 Goodwill and other intangible assets 6,456 6,653 2,310 Other assets 14,042 12,845 11,356 -------- -------- -------- Total assets $437,961 $421,394 $285,884 -------- -------- -------- -------- -------- -------- LIABILITIES Deposits Noninterest-bearing demand $ 63,114 $ 58,836 $ 35,179 Negotiable orders of withdrawal 53,509 54,202 35,002 Savings 151,138 143,562 111,903 Time, under $100,000 74,902 69,534 51,082 Time, $100,000 and over 30,557 30,261 14,280 -------- -------- -------- Total deposits 373,220 356,395 247,446 Borrowed funds 21,429 22,049 12,388 Accrued interest, taxes and other liabilities 2,162 2,702 4,381 -------- -------- -------- Total Liabilities 396,811 381,146 264,215 SHAREHOLDERS' EQUITY Preferred Stock, no par value; 10,000,000 shares authorized; none outstanding - - - Common stock, no par value, 20,000,000 shares authorized; 4,381,975 issued & outstanding at March 31, 1998; 4,376,975 issued & outstanding at December 31, 1997; and 2,606,478 issued & outstanding at 33,978 33,928 15,592 March 31, 1997 Retained earnings 6,962 6,125 6,239 Investment securities unrealized gains(losses), net 210 195 (162) -------- -------- -------- Total shareholders' equity 41,150 40,248 21,669 -------- -------- -------- Total liabilities and shareholders' equity $437,961 $421,394 $285,884 -------- -------- -------- -------- -------- -------- 3 Capital Corp of The West Consolidated Statements of Income (Unaudited) Three Months Ending Three Months Ending (In thousands except share data) 3/31/98 3/31/97 Interest income: Interest and fees on loans $5,699 $4,687 Interest on taxable investment securities held to maturity 205 248 Interest on investment securities available for sale: Taxable 1,794 562 Non-taxable 121 59 Interest on federal funds sold 273 45 ------ ------ Total interest income 8,092 5,601 Interest expense: Deposits: Negotiable orders of withdrawal 118 78 Savings 1,434 1,122 Time, under $100,000 1,050 660 Time, $100,000 and over 365 139 Other 336 73 ------ ------ Total interest expense 3,303 2,072 Net interest income 4,789 3,529 Provision for loan losses 252 240 ------ ------ Net interest income after provision for loan losses 4,537 3,289 Other income: Service charges on deposit accounts 648 337 Income from real estate held for sale or development 22 7 Other 388 390 ------ ------ Total other income 1,058 734 Other Expenses: Salaries and related benefits 1,963 1,544 Premises and occupancy 325 279 Equipment 502 287 Professional fees 154 141 Marketing 102 159 Goodwill and intangible amortization 198 36 Branch purchase 101 - Supplies 151 98 Other 827 696 ------ ------ Total other expenses 4,323 3,240 Income before income taxes 1,272 783 Provision for income taxes 435 270 ------ ------ Net income $ 837 $ 513 ------ ------ Basic earnings per share $ 0.18 $ 0.19 ------ ------ ------ ------- Weighted average shares outstanding (000) 4,599 2,724 ------ ------ ------ ------- 4 Capital Corp of The West Statement of Consolidated Cash Flows (Unaudited) 3 months ended 3 months ended 3/31/98 3/31/97 --------------- --------------- (In thousands) OPERATING ACTIVITIES: Net Income $ 837 $ 513 Adjustments to reconcile net income to net cash provided by operating activities: Provision for loan losses 252 240 Depreciation, amortization and accretion, net 752 281 Benefit for deferred income taxes - (65) Gain on sale of real estate held for sale 22 - Net (increase) in interest receivable & other assets (367) (415) Net decrease in mortgage loans held for sale - 880 Net (decrease) increase in deferred loan fees (23) 57 Net (decrease) increase in accrued interest payable & other liabilities (540) 1,606 ------- -------- Net cash provided by operating activities 933 3,097 INVESTING ACTIVITIES: Investment security purchases (21) (17,788) Proceeds from maturities of investment securities 15,219 2,899 Proceeds from sales of investment securities 15,615 2,519 Net increase in time deposits in other financial institiutions (401) - Proceeds from sales of commercial and real estate loans 814 205 Net increase in loans (4,208) (5,428) Purchases of premises and equipment (637) (2,051) Net increase in real estate held for sale or development (478) (72) ------- -------- Net cash provided (used) by investing activities 25,903 (19,716) FINANCING ACTIVITIES: Net increase (decrease) in demand, NOW and deposits 11,161 (2,661) Net increase in certificates of deposit 5,664 11,762 Net (decrease) increase in other borrowings (620) 8,493 Issued shares for benefit plan purchases - 176 Exercise of stock options 50 99 ------- -------- Net cash provided by financing activities 16,255 17,869 Net increase in cash and cash equivalents 43,091 1,250 Cash and cash equivalents at beginning of year 23,435 16,717 ------- -------- Cash and cash equivalents at end of quarter $66,526 $ 17,967 SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Investment securities net unrealized gains (losses) $ 15 $ (152) 5 Capital Corp of the West Notes to Consolidated Financial Statements March 31, 1998, December 31, 1997, and March 31, 1997 (Unaudited) GENERAL - COMPANY Capital Corp of the West (the "Company" or "Capital Corp") is a bank holding company incorporated under the laws of the state of California on April 26, 1995. On November 1, 1995, the Company became registered as a bank holding company, and is a holder of all of the capital stock of County Bank (the "Bank") and all of the capital stock of Town and Country Finance and Thrift (the "Thrift"). During 1997 the Company formed Capital West Group, a new subsidiary that engages in the financial institution advisory business but is currently inactive. The Company's primary asset is the Bank and the Bank is the Company's primary source of income. The Company's securities consist of 20,000,000 shares of Common Stock, no par value, and 10,000,000 shares of Preferred Stock. As of March 31, 1998 there were 4,381,975 common shares outstanding, held of record by approximately 1,300 shareholders. There were no preferred shares outstanding at March 31, 1998. The Bank has two wholly owned subsidiaries, Merced Area Investment & Development, Inc. ("MAID") and County Asset Advisors ("CAA"). CAA is currently inactive. All references herein to the "Company" include the Bank, and the Bank's subsidiaries, Capital West Group and the Thrift, unless context otherwise requires. GENERAL - BANK The Bank was organized on August 1, 1977, as County Bank of Merced, a California state banking corporation. The Bank commenced operations on December 22, 1977. In November 1992, the Bank changed its legal name to County Bank. The Bank's securities consist of one class of Common Stock, no par value and is wholly owned by the Company. The Bank's deposits are insured under the Federal Deposit Insurance Act, by the Federal Deposit Insurance Corporation ("FDIC") up to applicable limits stated therein. Like most state-chartered banks of its size in California, it is not a member of the Federal Reserve System. GENERAL - THRIFT The Company acquired the Thrift on June 28, 1996 for a combination of cash and stock with an aggregate value of approximately $5.8 million. The Thrift is an industrial loan company with four offices. It specializes in direct loans to the public and the purchase of financing contracts. It was originally incorporated in 1957. Its deposits (technically known as investment certificates or certificates of deposit rather than deposits) are insured by the FDIC up to applicable limits. BANK'S INDUSTRY AND MARKET AREA The Bank engages in general commercial banking business primarily in Merced, Tuolumne, Mariposa, Madera and Stanislaus counties. The Bank has thirteen branch offices: two in Merced with the branch located in north Merced currently designated as the head office, offices in Atwater, Turlock, Hilmar, Sonora, Los Banos, Mariposa, Livingston, Dos Palos, Madera and two offices in Modesto. The Bank relocated its existing administrative office and existing branch in downtown Merced to a new facility constructed in 1997. The Thrift engages in the general consumer lending business primarily in Stanislaus, Fresno, and Tulare counties from its main office in Turlock; and branch offices located in Modesto, Visalia, and Fresno. OTHER FINANCIAL NOTES All adjustments, in the opinion of Management, which are necessary for a fair presentation of the Company's financial position at March 31, 1998, December 31, 1997, and at March 31 1997 and the results of operations and statements of cash flows for the three month periods ended March 31, 1998 and 1997, have been included. These interim statements are not necessarily indicative of the results for a full year. 6 The accompanying unaudited financial statements have been prepared on a basis consistent with the generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Per share information is based on weighted average number of shares of common stock outstanding during each three-month period after giving retroactive effect for the five percent stock dividend declared for shareholders of record May 7, 1998, payable June 1, 1998, the three-for-two stock split declared for shareholders of record on April 11, 1997, payable on May 2, 1997. The weighted average number of shares outstanding were 4,599,000 for the three-month period ended March 31, 1998 and 2,724,000 for March 31, 1997. Comprehensive Income for Capital Corp of the West for the periods ending March 31, 1998 and March 31, 1997 were $852,000 or $.19 per share and $606,000 or $.22 per share respectively. In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Board No. 130, "Reporting Comprehensive Income". Under the provisions of SFAS 130, the Company is required to report comprehensive income in its financial statements, the term comprehensive income describes the total of all components of comprehensive income including net income as well as other revenues, expenses, gains and losses that are included in comprehensive income but excluded from earnings (net income). The Company started to report comprehensive income as part of its notes to financial statements, including other comprehensive income items added separately to net income resulting in total comprehensive income. SFAS 130 is effective with the year-end 1998 financial statements, however, the total comprehensive income is required in the financial statements for interim periods beginning in 1998. The Company adopted SFAS 130 as of January 1, 1998, the adoption of the statement did not have a material impact on the Company's financial statements. In June 1997, the FASB issued SFAS No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION. SFAS No. 131 is effective for annual periods beginning after December 1, 1997 and is to be applied retroactively to all periods presented. SFAS No. 131 establishes standards for the way public business enterprises are to report information about operating segments in annual financial statements and requires those enterprises to report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. SFAS No. 131 supersedes SFAS No. 14, FINANCIAL REPORTING FOR SEGMENTS OF A BUSINESS ENTERPRISE but retains the requirement to report information about major customers. Management does not expect that adoption of SFAS No. 131 will have a material impact on the Company's consolidated financial statements. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS THE FOLLOWING MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS. THESE FACTORS INCLUDE GENERAL RISKS INHERENT TO COMMERCIAL LENDING; RISKS RELATED TO ASSET QUALITY; RISKS RELATED TO THE COMPANY'S DEPENDENCE ON KEY PERSONNEL AND ITS ABILITY TO MANAGE EXISTING AND FUTURE GROWTH; RISKS RELATED TO COMPETITION; RISKS POSED BY PRESENT AND FUTURE GOVERNMENT REGULATION AND LEGISLATION; AND RISKS RESULTING FROM FEDERAL MONETARY POLICY. The following discussion and analysis is designed to provide a better understanding of the significant changes and trends related to the Company and its subsidiaries' financial condition, operating results, asset and liability management, liquidity and capital resources and should be read in conjunction with the Consolidated Financial Statements of the Company and the Notes thereto. RESULTS OF OPERATIONS THREE MONTHS ENDED MARCH 31, 1998 COMPARED WITH THREE MONTHS ENDED MARCH 31, 1997 OVERVIEW. For the three months ended March 31, 1998, the Company reported net income of $837,000 compared with net income of $513,000 for the three months ended March 31, 1997. Earnings per share were $.18 and $.19, respectively. The annualized return on average assets was .78% and .76% for the first three months of 1998 and 1997, respectively. The Company's annualized return on average equity was 8.12% and 9.61% for the three months ended March 31, 1998 and 1997, respectively. NET INTEREST INCOME. The Company's primary source of income is the difference between interest income and fees derived from earning assets and interest paid on liabilities. The difference between the two is net interest income. Net interest income for the three months ended March 31, 1998 totaled $4,789,000 compared with $3,529,000 for the same period in 1997, an increase of $1,260,000 or 36%. Total interest and fees on earning assets were $8,092,000 for the first three months of 1998, an increase of $2,491,000 or 44% from $5,601,000 for the same three months in 1997. The level of interest income is affected by changes in volume of and rates earned on interest-earning assets. Interest-earning assets consist primarily of loans, 7 investment securities and federal funds sold. The increase in interest income in the first three months of 1998 was primarily the result of an increase in the volume of interest-earning assets. Average interest-earning assets for the first three months of 1998 were $375,683,000 compared with $240,196,000 for the first three months of 1997, an increase of $135,487,000 or 56%. Interest expense is a function of the volume of and the rates paid on interest-bearing liabilities. Interest-bearing liabilities consist primarily of certain deposits and borrowed funds. Total interest expense was $3,303,000 for the three months ended March 31, 1998, compared with $2,072,000 for the three months ended March 31, 1997, an increase of $1,231,000 or 59%. This increase was primarily the result of an increase in the volume of interest-bearing liabilities. Average interest-bearing liabilities were $326,930,000 for the first three months of 1997 compared with $211,161,000 for the same three months in 1997, an increase of $115,769,000 or 55%. The increase in interest-earning assets and interest-bearing liabilities is primarily the result of the Company's purchase of three branches of Bank of America in December 1997 and the completion of a successful stock offering in August 1997. The branch purchase increased deposits by $60,849,000 (there were no loans purchased) and the stock offering increased capital by $17,951,000. In addition, two branch offices opened in late 1996 and a third in late 1997 which also contributed to growth. The Company's net interest margin, the ratio of net interest income to average interest-earning assets, was 5.17% for the three months ended March 31, 1998 compared with 5.96% for the same period in 1997. Net interest margin provides a measurement of the Company's ability to employ funds profitably during the period being measured. The Company's decrease in net interest margin was primarily attributable to a moderate change in the mix of interest-earning assets. Loans as a percentage of average interest-earning assets decreased from 77% for the three months ended March 31, 1997 to 58% for the three months ended March 31, 1998. AVERAGE BALANCES AND RATES EARNED AND PAID. The following table presents condensed average balance sheet information for the Company, together with interest rates earned and paid on the various sources and uses of its funds for each of the periods indicated. Nonaccruing loans are included in the calculation of the average balances of loans, but the nonaccrued interest on such loans is excluded. Average Balance Sheet And Analysis of Net Interest Income Three Months ended Three Months ended March 31, 1998 March 31, 1997 Average Average Balance Interest Yield/rate Balance Interest Yield/rate (DOLLARS IN THOUSANDS) ASSETS Federal funds sold $ 20,041 $ 273 5.52% $ 3,589 $ 45 5.09% Taxable investment securities: 128,828 1,999 6.29% 47,994 810 6.85% Nontaxable investment securities (1) 9,215 121 5.33% 4,195 59 5.70% Loans, gross: (2) 217,599 5,699 10.62% 184,418 4,687 10.31% --------- ---------- ----------- ----------- ---------- ----------- Total interest-earning assets: 375,683 8,092 8.74% 240,196 5,601 9.46% Allowance for loan losses (4,073) (2,977) Cash and due from banks 20,606 10,806 Premises and equipment, net 13,153 7,334 Interest receivable and other assets 22,094 15,516 -------- -------- Total assets $427,463 $270,875 -------- -------- -------- -------- LIABILITIES AND SHAREHOLDERS' EQUITY Negotiable order of withdrawal $ 53,560 $ 118 0.89% $ 33,368 $ 78 0.95% Savings deposits 148,508 1,434 3.92% 112,564 1,122 4.04% Time deposits 102,965 1,415 5.57% 59,415 799 5.45% Other borrowings 21,898 336 6.22% 5,814 73 5.09% --------- ---------- ----------- ----------- ---------- ----------- Total interest-bearing liabilities 326,930 3,303 4.10% 211,161 2,072 3.98% 8 Noninterest-bearing deposits 56,419 32,871 Accrued interest, taxes and other liabilities 2,342 5,432 --------- ----------- Total liabilities 385,691 249,464 Total shareholders' equity 41,772 21,411 --------- ----------- Total liabilities and shareholders' equity $427,463 $270,875 --------- ----------- --------- ----------- Net interest income and margin (3) $ 4,789 5.17% $ 3,529 5.96% -------- ---- --------- ---- -------- ---- --------- ---- (1) Interest on nontaxable securities is not computed on a tax-equivalent basis. (2) Amounts of interest earned includes loan fees of $343,000 and $233,000 for March 31, 1998 and 1997 respectively. (3) Net interest margin is computed by dividing net interest income by total average interest-earning assets. 9 NET INTEREST INCOME CHANGES DUE TO VOLUME AND RATE. The following table sets forth, for the periods indicated, a summary of the changes in average asset and liability balances and interest earned and interest paid resulting from changes in average asset and liability balances (volume) and changes in average interest rates and the total net change in interest income and expenses. The changes in interest due to both rate and volume have been allocated to volume and rate changes in proportion to the relationship of the absolute dollar amount of the change in each. Net Interest Income Variance Analysis: March 31, 1998 compared to March 31, 1997 Volume Rate Total -------- ---- ----- (Dollar amounts in thousands) Increase (decrease) in interest income: Taxable investment securities $ 1,640 (451) 1,189 Tax-exempt investment securities 89 (27) 62 Federal funds sold 224 4 228 Loans 865 147 1,012 ------ ---- ----- Total 2,818 (327) 2,491 ------ ---- ----- ------ ---- ----- Increase (decrease) in interest expense: Interest-bearing demand 70 (30) 40 Savings deposits 544 (232) 312 Time deposits 598 18 616 Other borrowings 243 20 263 ------ ---- ----- Total 1,455 (224) 1,231 ------ ---- ----- ------ ---- ----- Increase (decrease) in net interest income $ 1,363 $ (103) $ 1,260 ------ ---- ----- ------ ---- ----- PROVISION FOR LOAN LOSSES. The provision for loan losses for the first three months of 1998 was $252,000 compared with $240,000 in the three months ended March 31, 1997. As of March 31, 1998 the allowance for loan losses was $3,799,000 or 1.72% of total loans. At March 31, 1998, nonperforming assets totaled $1,802,000 or .41% of total assets, nonperforming loans totaled $1,279,000 or .81% of total loans and the allowance for loan losses totaled 297.02% of nonperforming loans. No assurance can be given that nonperforming loans will not increase or that the allowance for loan losses will be adequate to cover losses inherent in the loan portfolio. Also see "Memorandum of Understanding" contained herein. NONINTEREST INCOME. Noninterest income increased by $324,000 or 44% to $1,058,000 for the three months ended March 31, 1998 compared with $734,000 in the same period in 1997. Service charges on deposit accounts increased by $311,000 or 92%, income from the sale of real estate held for sale or development increased by $15,000 or 214% and other income decreased by $2,000 or 1%. The increases in service charges are primarily due to general growth of the Company and the purchases of the branches from Bank of America. NONINTEREST EXPENSE. Noninterest expenses increased by $1,083,000 or 33% to $4,323,000 for the three months ended March 31, 1998 compared with $3,240,000 for the same period in 1997. The primary components of noninterest expenses were salaries and employee benefits, occupancy expenses, furniture and equipment expenses, and other operating expenses. For the three months ended March 31, 1998 compared with the three months ended March 31, 1997, salaries and related benefits increased by $419,000 or 27%, equipment expenses increased $215,000 or 75%, occupancy expenses increased $46,000 or 17%, marketing expenses decreased by $57,000 or 36% and other expenses, including professional fees, and supplies increased by $281,000 or 11%. The expense increases were primarily the result of expansion, including expenses associated with acquisition, operation and staffing of the branches purchased from Bank of America in December, 1997 and the opening of a new branch in Madera in late 1997. 10 PROVISION FOR INCOME TAXES. The Company recorded a $435,000 tax expense for the three months ended March 31, 1998 compared with $270,000 for the same three months in 1997. Tax rates were positively affected by the purchase of limited partnership investments in low-income affordable housing projects providing the investor with affordable housing income tax credits. The Company had investments in these partnerships of $4,300,000 as of March 31, 1998 and $2,700,000 as of March 31, 1997, resulting in tax credits of $79,000 and $35,000 respectively. INTEREST RATE RISK Interest rate risk is an integral part of managing a banking institution's primary source of income, net interest income. The Company manages the balance between rate-sensitive assets and rate-sensitive liabilities being repriced in any given period with the objective of stabilizing net interest income during periods of fluctuating interest rates. The Company considers its rate-sensitive assets to be those which either contain a provision to adjust the interest rate periodically or mature within one year. These assets include certain loans and investment securities and federal funds sold. Rate-sensitive liabilities are those which allow for periodic interest rate changes within one year and include maturing time certificates, certain savings deposits and interest-bearing demand deposits. The difference between the aggregate amount of assets and liabilities that reprice within various time frames is called the "gap." Generally, if repricing assets exceed repricing liabilities in a time period the Company would be deemed to be asset-sensitive. If repricing liabilities exceed repricing assets in a time period the Company would be deemed to be liability-sensitive. Generally, the Company seeks to maintain a balanced position whereby there is no significant asset or liability sensitivity within a one-year period to ensure net interest margin stability in times of volatile interest rates. This is accomplished through maintaining a significant level of loans, investment securities and deposits available for repricing within one year. The following tables set forth the interest rate sensitivity of the Bank's interest-earning assets and interest-bearing liabilities as of March 31, 1998, using the interest rate sensitivity gap ratio. For purposes of the following table, an asset or liability is considered rate-sensitive within a specified period when it can be repriced or matures within its contractual terms. AT MARCH 31, 1998 ------------------------------------------------------------------------------------- AFTER 3 AFTER 1 BUT YEAR BUT WITHIN WITHIN WITHIN AFTER NONINTEREST- 3 MONTHS 12 MONTHS 5 YEARS 5 YEARS BEARING TOTAL -------- --------- --------- -------- ------------ ------ (DOLLARS IN THOUSANDS) ASSETS Time deposits at other banks $ 250 $ 750 $ - $ - $ - $ 1,000 Federal funds sold 44,900 - - - - 44,900 Investment securities 3,445 21,181 7,813 84,560 - 116,999 Loans 124,194 27,494 56,087 13,333 - 221,108 -------- --------- --------- -------- ------------ --------- Total earning assets 172,789 49,425 63,900 97,893 - 384,007 Noninterest-earning assets and allowances for loan losses - - - - 53,954 53,954 -------- --------- --------- -------- ------------ --------- Total assets $ 172,789 $ 49,425 $ 63,900 $ 97,893 $ 53,954 $ 437,961 LIABILITIES AND SHAREHOLDERS' EQUITY Savings, money market and NOW deposits $ 204,647 $ - $ - $ - $ - $ 204,647 Time deposits 18,518 65,590 21,351 - - 105,459 Other interest-bearing liabilities - 18,029 103 3,297 - 21,429 Other liabilities and shareholders' equity - - - - 106,426 106,426 Total liabilities and shareholders' equity 223,165 83,619 21,454 3,297 106,426 $ 437,961 Incremental gap (50,376) (34,194) 42,446 94,596 (52,472) Cumulative gap $(50,376) $ (84,570) $ (42,124) $ 52,472 $ - -------- --------- --------- -------- --------- -------- --------- --------- -------- --------- Cumulative gap as a % of earning assets (13.1)% (22.1)% (10.9)% 53.9% 11 The Company was liability-sensitive with a negative cumulative one-year gap of $84,570,000 or 22.1% of interest-earning assets at March 31, 1998. In general, based upon the Company's mix of deposits, loans and investments, increases in interest rates would be expected to result in a decrease in the Company's net interest margin. The interest rate gaps reported in the tables arise when assets are funded with liabilities having different repricing intervals. Since these gaps are actively managed and change daily as adjustments are made in interest rate views and market outlook, positions at the end of any period may not be reflective of the Company's interest rate sensitivity in subsequent periods. Active management dictates that longer-term economic views are balanced against prospects for short-term interest rate changes in all repricing intervals. For purposes of the analysis above, repricing of fixed-rate instruments is based upon the contractual maturity of the applicable instruments. Actual payment patterns may differ from contractual payment patterns. The change in net interest income may not always follow the general expectations of an asset-sensitive or liability-sensitive balance sheet during periods of changing interest rates, because interest rates earned or paid may change by differing increments and at different time intervals for each type of interest-sensitive asset and liability. As a result of these factors, at any given time, the Company may be more sensitive or less sensitive to changes in interest rates than indicated in the above tables. Greater sensitivity would have a more adverse effect on net interest margin if market interest rates were to increase, and a more favorable effect if rates were to decrease. An additional measure of interest rate sensitivity that the Company monitors through a detailed model is its expected change in earnings. This model's estimate of interest rate sensitivity takes into account the differing time intervals and differing rate change increments of each type of interest-sensitive asset and liability. It then measures the projected impact of changes in market interest rates on the Company's return on equity. Based upon the March 31, 1998 mix of interest-sensitive assets and liabilities, given an immediate and sustained increase in the federal funds rate of 1%, this model estimates the Company's cumulative return on equity over the next year would decrease by less than 1%. No assurance can be given that the actual return on equity would not decrease by more than 1% in response to a 1% increase in federal funds rate, or that actual return on equity would not decrease substantially if market interest rates increased by more than 1%. Also see "Memorandum of Understanding" contained herein. The Bank's most recent examination, the regulators felt that the current model that is used by the Bank was not adequate for a bank of its current size and complexity. The Bank is currently updating the model it uses for interest rate risk analysis and expects to have this new model in place by June 30, 1998. FINANCIAL CONDITION Total assets at March 31, 1998 were $437,961,000, an increase of $16,567,000 or 4% compared with total assets of $421,394,000 at December 31, 1997, and an increase of $152,077,000 or 53% compared with total assets of $285,884,000 at March 31, 1997. Net loans were $217,309,000 at March 31, 1998, an increase of $3,165,000 or 2% compared with net loans of $214,144,000 on December 31, 1997, and an increase of $31,928,000 or 17% compared with net loans of $185,381,000 at March 31, 1997. Deposits were $373,220,000 at March 31, 1998, an increase of $16,825,000 or 5% compared with deposits of $356,395,000 at December 31, 1997, and an increase of $125,774,000 or 51% compared with deposits of $247,446,000 at March 31, 1997. The growth of the Company from March 31, 1997 to March 31, 1998 was primarily the result of the purchase of three branch offices of Bank of America in December 1997, a successful capital offering in 1997 and the opening of a branch office of County Bank in late 1997. Total shareholders' equity was $41,150,000 at March 31, 1998, an increase of $902,000 or 2% from $40,248,000 at December 31, 1997, and a 90% increase from $21,669,000 at March 31, 1997. The growth in shareholders' equity was primarily due to the issuance of 1,725,000 additional shares of no par common stock which generated a net addition of $17,951,000 to shareholders' equity in August 1997. INVESTMENT PORTFOLIO. The following table sets forth the carrying amount (fair value) of available for sale investment securities as of March 31, 1998 and 1997, and December 31, 1997. 12 MARCH 31 DECEMBER 31 ------------------ ----------- 1998 1997 1997 --------- ------- ----------- (Dollars in thousands) AVAILABLE FOR SALE SECURITIES: U.S. Treasury and U.S. Government agencies $ 817 $ 5,599 $ 1,824 State and political subdivisions 8,739 4,254 9,640 Mortgage-backed securities 65,393 34,669 68,808 Collateralized mortgage obligations 29,129 0 51,874 Other securities 3,132 1,524 3,111 --------- -------- --------- Carrying amount and fair value $ 107,210 $ 46,046 $ 135,257 --------- -------- --------- --------- -------- --------- The following table sets forth the carrying amount (amortized cost) and fair value of held to maturity securities at March 31, 1998 and 1997, and December 31, 1997. MARCH 31 DECEMBER 31 ---------------------------- ----------- (Dollars in thousands) 1998 1997 1997 ---- ---- ---- HELD TO MATURITY SECURITIES: U.S. Treasury and U.S. Government agencies $ 6,439 $ 11,456 $ 9,442 Mortgage-backed securities 3,350 - 3,333 ------------- ----------- --------- Carrying amount (amortized cost) 9,789 11,456 12,775 ------------- ----------- --------- ------------- ----------- --------- Fair value $ 9,791 $ 11,058 $ 12,780 ------------- ----------- --------- ------------- ----------- --------- The following table sets forth the maturities of the Company's investment securities at March 31, 1998 and the weighted average yields of such securities calculated on the basis of the cost and effective yields based on the scheduled maturity of each security. Maturities of mortgage-backed securities are stipulated in their respective contracts. However, actual maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call prepayment penalties. Yields on municipal securities have not been calculated on a tax-equivalent basis. AT MARCH 31, 1998 ----------------------------------------------------------------------------------------------- WITHIN ONE YEAR ONE TO 5 YEARS FIVE TO TEN YEARS OVER TEN YEARS TOTAL ------------------ ----------------- ------------------ ------------------------------- AMOUNT YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT YIELD AMOUNT -------- ------- --------- ------- ------- -------- --------- ------- --------- (Dollars in thousands) Available for Sale Securities: Treasury and U.S. Government agencies $ - - $ 505 5.52% $ - - $ 312 7.40 % $ 817 State and political 420 3.54% 801 3.71 - - 7,517 5.01 8,739 Mortgage-backed securities - - 440 5.94 2,815 6.27% 59,478 6.11 62,734 Collateralized mortgage obligations - - 16,164 6.72 - - 15,625 6.64 31,789 Other securities - - - - - - 3,132 - 3,132 -------- ------- --------- ------- ------- -------- --------- ------- --------- Carrying amount and fair value 420 3.54% 17,912 6.53% 2,815 6.27% 86,064 6.12 % 107,210 -------- ------- --------- ------- ------- -------- --------- ------- --------- -------- ------- --------- ------- ------- -------- --------- ------- --------- Held to maturity securities: Treasury and U.S. Government - - - - 4,039 6.95 2,400 7.17 6,439 agency Mortgage-backed securities - - - - - - 3,350 7.35 3,350 -------- ------- --------- ------- ------- -------- --------- ------- --------- Carrying amount (amortized cost) - - - - 4,039 6.95 5,750 7.27 9,789 -------- ------- --------- ------- ------- -------- --------- ------- --------- Total securities $ 420 3.54% $ 17,912 6.53% $ 6,854 6.67% $ 91,813 5.98 % $116,999 13 In the above table, mortgage-backed securities and collateralized mortgage obligations are shown repricing at the time of maturity rather than in accordance with their principal amortization schedules. The Company does not own securities of a single issuer whose aggregate book value is in excess of 10% of its total equity. Also see "Memorandum of Understanding" contained herein. LOAN PORTFOLIO. The following table shows the composition of the Company's loan portfolio at the dates indicated. AT MARCH 31, AT DECEMBER 31, --------------------------------------------------- ------------------ 1998 1997 1997 ----------------------- ------------------------ ------------------ (DOLLARS IN THOUSANDS) Dollar Amount Percent Dollar Amount Percent of Dollar Percent Loan Categories: of loans loans Amount of loans - ---------------- ------------- --------- ------------- ---------- ------- -------- Commercial $ 37,360 17 % $ 28,261 15% $ 34,992 16% Agricultural 41,337 19 42,633 23 43,558 20 Real estate-construction 13,101 6 14,796 8 12,657 6 Real estate-mortgage 70,711 32 59,869 32 70,802 32 Consumer 58,599 26 42,496 22 55,968 26 -------- ----- -------- --- -------- --- Total 221,108 100 % $188,055 100% $217,977 100% Less allowance for loan losses (3,799) (2,674) (3,833) -------- -------- -------- Net loans $217,309 $185,381 $214,144 -------- -------- -------- -------- -------- -------- The following tables show the maturity distribution of the loan portfolio at March 31, 1998. AT MARCH 31, 1998 -------------------------------------------------------- AFTER 1 BUT WITHIN 1 YEAR WITHIN 5 YEARS AFTER 5 YEARS TOTAL ------------- -------------- ------------- ----- (IN THOUSANDS) Commercial and agricultural Loans with floating interest rates $45,187 $14,083 $ 5,591 $ 64,861 Loans with fixed interest rates 4,671 5,212 837 10,720 ------- ------- ------- -------- Subtotal 49,858 19,295 6,428 75,581 ------- ------- ------- -------- Real estate-construction Loans with floating interest rates 6,922 1,279 1,877 10,078 Loans with fixed interest rates 1,617 1,266 137 3,020 ------- ------- ------- -------- Subtotal 8,539 2,545 2,014 13,098 ------- ------- ------- -------- Real estate-mortgage 5,092 40,273 25,537 70,902 Consumer 30,713 29,888 926 61,527 ------- ------- ------- -------- Total $94,202 $92,001 $34,905 $221,108 ------- ------- ------- -------- ------- ------- ------- -------- OFF-BALANCE SHEET COMMITMENTS. The following table shows the Company's undisbursed loan commitments at the dates indicated. MARCH 31, DECEMBER 31, ------------------- -------------- 1998 1997 1997 ---- ---- ---- (IN THOUSANDS) Letters of credit $ 2,740 $ 2,267 $ 3,233 Commitments to extend credit 73,191 48,111 55,248 ------- ------- ------- Total $75,931 $50,378 $58,481 ------- ------- ------- ------- ------- ------- 14 OTHER INTEREST-EARNING ASSETS. The following table relates to other interest-earning assets not disclosed previously for the dates indicated. This item consists of a salary continuation plan for the Company's executive management and deferred retirement benefits for participating board members. The plan is informally linked with universal life insurance policies for the salary continuation plan. Income from these policies is reflected in noninterest income. AT MARCH 31, AT DECEMBER 31, ---------------------- ---------------- 1998 1997 1997 ---- ---- ---- (IN THOUSANDS) Cash surrender value of life insurance $ 3,974 $ 3,172 $ 3,839 ---------- -------- -------- ---------- -------- -------- NONPERFORMING ASSETS. Nonperforming assets include nonaccrual loans, loans 90 days or more past due, restructured loans and other real estate owned. Nonperforming loans are those which the borrower fails to perform in accordance with the original terms of the obligation and include loans on nonaccrual status, loans past due 90 days or more and restructured loans. The Company generally places loans on nonaccrual status and accrued but unpaid interest is reversed against the current year's income when interest or principal payments become 90 days or more past due unless the outstanding principal and interest is adequately secured and, in the opinion of management, is deemed in the process of collection. Interest income on nonaccrual loans is recorded on a cash basis. Payments may be treated as interest income or return of principal depending upon management's opinion of the ultimate risk of loss on the individual loan. Cash payments are treated as interest income where management believes the remaining principal balance is fully collectible. Additional loans not 90 days past due may also be placed on nonaccrual status if management reasonably believes the borrower will not be able to comply with the contractual loan repayment terms and collection of principal or interest is in question. A "restructured loan" is a loan on which interest accrues at a below market rate or upon which certain principal has been forgiven so as to aid the borrower in the final repayment of the loan, with any interest previously accrued, but not yet collected, being reversed against current income. Interest is reported on a cash basis until the borrower's ability to service the restructured loan in accordance with its terms is established. The Company had no restructured loans as of the dates indicated in the table below. The following table summarizes nonperforming assets of the Company at March 31, 1998 and 1997 and at December 31, 1997: March 31, At December 31, ------------------- --------------- (Dollars in thousands) 1998 1997 1997 ---- ---- ---- Nonaccrual loans $ 823 $5,101 $2,611 Accruing loans past due 90 days or more 456 1,565 131 ------ ------ ------ Total nonperforming loans 1,279 6,666 2,742 Other real estate owned 523 1,466 60 ------ ------ ------ Total nonperforming assets $1,802 $8,132 $2,802 ------ ------ ------ ------ ------ ------ Nonperforming assets: To total loans .81% 4.32% 1.29% 15 To total assets .41% 2.84% .66% Interest income on loans on nonaccrual status during the three months ended March 31, 1998, and the three months ended March 31, 1997, that would have been recognized if the loans had been current in accordance with their original terms was approximately $143,000 and $511,000, respectively. At March 31, 1998, nonperforming assets represented .41% of total assets, and nonperforming loans represented .81% of total loans. Nonperforming loans that were secured by first deeds of trust on real property were $145,000 at March 31, 1998 and $1,635,000 at December 31, 1997. Other forms of collateral such as inventory and equipment secured the remaining nonperforming loans as of each date. No assurance can be given that the collateral securing nonperforming loans will be sufficient to prevent losses on such loans. The decrease in nonperforming loans and nonperforming assets as of March 31, 1998 compared with their levels as of December 31, 1997, was due primarily to the payoff of a nonperforming commercial real estate loan with a principal balance of $384,000 and the return of a certain borrower's loans to accrual status with a principal balance of $478,000. At March 31, 1998, the Company had $523,000 in two properties acquired through foreclosure. These properties are carried at the lower of its estimated market value, as evidenced by an independent appraisal, or the recorded investment in the related loan, less estimated selling expenses. At foreclosure, if the fair value of the real estate is less than the Company's recorded investment in the related loan, a charge is made to the allowance for loan losses. The Company expects to sell one of these properties during 1998. No assurance can be given that the Company will sell such property in 1998 or at any time or the amount for which such property might be sold. In addition to property acquired through foreclosure, the Company has investments in residential real estate lots in various stages of development in Merced County through MAID. MAID held two separate properties for sale or development at March 31, 1998. These investments were completely written off in 1995, although County Bank still retains title to these properties. In the first quarter of 1998, one lot was sold for a pre-tax gain of $22,000. Management defines impaired loans, regardless of past due status on loans, as those on which principal and interest are not expected to be collected under the original contractual loan repayment terms. An impaired loan is charged off at the time management believes the collection process has been exhausted. At March 31, 1998 and December 31, 1997, impaired loans were measured based on the present value of future cash flows discounted at the loan's effective rate, the loan's observable market price or the fair value of collateral if the loan is collateral-dependent. Impaired loans at March 31, 1998 were $823,000 (all of which were also nonaccrual loans), on account of which the Company had made provisions to the allowance for loan losses of $502,000. Except for loans that are disclosed above, there were no assets as of March 31, 1998, where known information about possible credit problems of the borrower causes management to have serious doubts as to the ability of the borrower to comply with the present loan repayment terms and which may become nonperforming assets. Given the magnitude of the Company's loan portfolio, however, it is always possible that current credit problems may exist that may not have been discovered by management. 16 ALLOWANCE FOR LOAN LOSSES The following table summarizes the loan loss experience of the Company for the quarter ended March 31, 1998 and 1997 and for years ended December 31, 1997, and 1996. MARCH 31 DECEMBER 31 ------------------------ ------------------------ 1998 1997 1997 1996 ---- ---- ---- ---- ALLOWANCE FOR LOAN LOSSES: Balance at beginning of period $ 3,833 $ 2,792 $ 2,792 $ 1,701 -------- -------- -------- -------- Provision for loan losses 252 240 5,825 1,513 Allowance acquired through merger - - - 148 Charge-offs: Commercial and agricultural 121 341 1,121 518 Real estate-construction - - 3,458 - Real estate-mortgage - - - - Consumer 223 77 471 140 -------- -------- -------- -------- Total charge-offs 344 418 5,050 658 -------- -------- -------- -------- Recoveries Commercial and agricultural 20 56 155 27 Real estate-construction - - 1 - Real estate-mortgage - - - - Consumer 37 4 110 61 -------- -------- -------- -------- Total recoveries 57 60 266 88 -------- -------- -------- -------- Net charge-offs 287 358 4,784 570 -------- -------- -------- -------- Balance at end of period $ 3,799 $ 2,674 $ 3,833 $ 2,792 -------- -------- -------- -------- -------- -------- -------- -------- Loans outstanding at period-end $221,108 $188,055 $217,977 $183,247 -------- -------- -------- -------- -------- -------- -------- -------- Average loans outstanding $217,599 $184,418 $198,140 $157,098 -------- -------- -------- -------- -------- -------- -------- -------- Net charge-offs to average loans .13 % .19 % 2.41 % 0.36 % Allowance for loan losses To total loans 1.72 1.42 1.76 1.52 To nonperforming assets 297.02 32.88 136.80 39.69 The Company maintains an allowance for loan losses at a level considered by management to be adequate to cover the inherent risks of loss associated with its loan portfolio under prevailing and anticipated economic conditions. In determining the adequacy of the allowance for loan losses, management takes into consideration growth trends in the portfolio, examination of financial institution supervisory authorities, prior loan loss experience for the Company, concentrations of credit risk, delinquency trends, general economic conditions, the interest rate environment and internal and external credit reviews. In addition, the risks management considers vary depending on the nature of the loan. The normal risks considered by management with respect to agricultural loans include the fluctuating value of the collateral, changes in weather conditions and the availability adequate water resources in the Company's local market area. The normal risks considered by management with respect to real estate construction loans include fluctuation in real estate values, the demand for improved commercial and industrial properties and housing, the availability of permanent financing in the Company's market area and borrowers' ability to obtain permanent financing. The normal risks considered by management with respect to real estate mortgage loans include fluctuations in the value of real estate. Additionally, the Company relies on data obtained through independent appraisal for significant properties to determine loss exposure on nonperforming loans. The balance in the allowance is affected by the amounts provided from operations, amounts charged off and recoveries of loans previously charged off. The Company recorded provisions for loan losses in the first three months of 1998 of $252,000 compared with $240,000 in the same period of 1997. 17 The Company made provisions to the allowance of $5,825,000 in the year ended December 31, 1997. The increase in loan loss provisions in 1997 was primarily due to increased reserves established for the commercial real estate development loan that was charged off in 1997 and, to a lesser extent, reserves to support the general loan growth of the Company. The Company's charge-offs, net of recoveries, were $287,000 for the three months ended March 31, 1998 compared with $358,000 for the same three months in 1997. The Company's charge-offs, net of recoveries, were $4,784,000 in the year ended December 31, 1997. The increase in net charge-offs for the year ended December 31, 1997 was primarily due to the write-off of the commercial real estate loan with a balance of $3,458,000. As of March 31, 1998, the allowance for loan losses was $3,799,000 or 1.72% of total loans outstanding, compared with $3,833,000 or 1.76% of total loans outstanding as of December 31, 1997 and $2,674,000 or 1.42% of total loans outstanding as of March 31, 1997. From 1992 to 1996, loan losses were relatively low and stable. In 1997, the Company experienced loan problems and made provisions at levels not previously experienced. As a result, the Company concluded that its historical method of determining the appropriate levels for its allowance and provisions for loan losses should be revised. The Company therefore adopted a new methodology of determining the appropriate level of its allowance for loan losses. This method, sometimes known as a migration analysis, applies relevant risk factors to the entire loan portfolio, including nonperforming loans. The methodology is based, in part, on the Bank's loan grading and classification system. The Bank grades its loans through internal reviews and periodically subjects loans to external reviews which then are assessed by the Bank's audit committee. Credit reviews are performed on a monthly basis and the quality grading process occurs on a quarterly basis. The "migration" of loans from grade to grade is then tracked to help predict future losses and thus more accurately set allowance levels. Risk factors applied to the performing loan portfolio are based on the Company's past loss history considering the current portfolio's characteristics, current economic conditions and other relevant factors. General reserves are applied to various categories of loans at percentages ranging up to 1.5% based on the Bank's assessment of credit risks for each category. Risk factors are applied to the carrying value of each classified loan: (i) loans internally graded "Watch" or "Special Mention" carry a risk factor from 1.0% to 2.0%; (ii) "Substandard" loans carry a risk factor from 3% to 40% depending on collateral securing the loan, if any; (iii) "Doubtful" loans carry a 50% risk factor; and (iv) "Loss" loans are charged off 100%. The analysis also includes reference to factors such as the delinquency status of the loan portfolio, inherent risk by type of loans, industry statistical data, recommendations made by the Company's regulatory authorities and outside loan reviewers, and current economic environment. Important components of the overall credit rating process are the asset quality rating process and the internal loan review process. The Company will also maintain its allowance at a level consistent with the requirements of the interagency Statement of Policy. This Statement includes a benchmark for the allowance to include amounts equal to 50% of loans classified "doubtful", 15% of loans classified "substandard", and an appropriate percentage of unclassified loans based upon historical loss experience and other factors. Also see "Memorandum of Understanding". The allowance is based on estimates and ultimate future losses may vary from current estimates. It is always possible that future economic or other factors may adversely affect the Company's borrowers, and thereby cause loan losses to exceed the current allowance. In addition, there can be no assurance that future economic or other factors will not adversely affect the Company's borrowers, or that the Company's asset quality may deteriorate through rapid growth, failure to enforce underwriting standards, 18 failure to maintain appropriate underwriting standards, failure to maintain an adequate number of qualified loan personnel, failure to identify and monitor potential problem loans or for other reasons, and thereby cause loan losses to exceed the current allowance. MARCH 31, 1998 DECEMBER 31, -------------- ------------ 1998 1997 1997 ---- ---- ---- AMOUNT AMOUNT AMOUNT TO TOTAL TO TOTAL TO TOTAL LOANS IN LOANS IN LOANS IN AMOUNT CATEGORY AMOUNT CATEGORY AMOUNT CATEGORY ------ -------- ------ -------- ------ -------- (DOLLARS IN THOUSANDS) Commercial and agricultural $ 1,833 48% $ 802 30% $ 1,868 48% Real estate- construction 681 18 1,364 31 640 17 Real estate- mortgage 1,013 27 214 8 1,058 28 Consumer 272 7 294 11% 267 7 ------- --- -------- --- -------- --- Total $ 3,799 100% $ 2,674 100% $ 3,833 100% ------- --- -------- --- -------- --- ------- --- -------- --- -------- --- The allocation of the allowance to loan categories is an estimate by management of the relative risk characteristics of loans in those categories. No assurance can be given that losses in one or more loan categories will not exceed the portion of the allowance allocated to that category or even exceed the entire allowance. See also "Memorandum Of Understanding" contained herein. EXTERNAL FACTORS AFFECTING ASSET QUALITY. As a result of the Company's loan portfolio mix, the future quality of its assets could be affected by adverse economic trends in its region or in the agricultural community. These trends are beyond the control of the Company. California is an earthquake-prone region. Accordingly, a major earthquake could result in material loss to the Company. At times the Company's service area has experienced other natural disasters such as floods and droughts. As recently as January of 1997, parts of the Company's market area experienced severe flooding. The Company's properties and substantially all of the real and personal property securing loans in the Company's portfolio are located in California. The Company faces the risk that many of its borrowers face uninsured property damage, interruption of their businesses or loss of their jobs from earthquakes, floods or droughts. As a result these borrowers may be unable to repay their loans in accordance with their terms and the collateral for such loans may decline significantly in value. The Company's service areas is a largely agricultural region and therefore is highly dependent on a reliable supply of water for irrigation purposes. The area obtains nearly all of its water from the run-off of melting snow in the mountains of the Sierra Nevada to the east. Although such sources have usually been available in the past, water supply can be adversely affected by light snowfall over one or more winters or by any diversion of water from its present natural courses. Any such natural disaster could impair the ability of many of the Company's borrowers to meet their obligations to the Company. Parts of California experienced significant floods in early 1998. The Company has completed an analysis of its collateral as a result of the recent floods. Current estimates indicate that there were no material adverse effects to the collateral position of the Company as a result of these events. No assurance can be given that future flooding will not have an adverse impact on the Company and its borrowers and depositors. LIQUIDITY. In order to maintain adequate liquidity, the Company must have sufficient resources available at all times to meet its cash flow requirements. The need for liquidity in a banking institution arises principally to provide for deposit withdrawals, the credit needs of its customers and to take advantage of investment opportunities as they arise. A company may achieve desired liquidity from both assets and liabilities. The Company considers cash and deposits held in other banks, federal funds sold, other short term investments, maturing loans and investments, payments of principal and interest on loans 19 and investments and potential loan sales as sources of asset liquidity. Deposit growth and access to credit lines established with correspondent banks and market sources of funds are considered by the Company as sources of liability liquidity. The Company reviews its liquidity position on a regular basis based upon its current position and expected trends of loans and deposits. These assets include cash and deposits in other banks, available-for-sale securities and federal funds sold. The Company's liquid assets totaled $171,604,000 $159,291,000 and $65,301,000 on March 31, 1998, December 31, 1997, and March 31, 1997, respectively, and constituted 39.2%, 37.8% and 22.8%, respectively, of total assets on those dates. Liquidity is also affected by the collateral requirements of its public deposits and certain borrowings. Total pledged securities were $47,295,000 at March 31, 1998 compared with $45,812,000 at December 31, 1997. When the Company acquired three Bank of America branches in December 1997, it acquired approximately $60,849,000 in deposits and no loans. In addition, the capital offering raised additional cash of $17,851,000. The Company initially invested this cash in liquid assets but intends over time to invest a larger portion of these funds in higher yielding assets such as loans. Although the Company's primary sources of liquidity include liquid assets and a stable deposit base, the Company maintains lines of credit with the Federal Reserve Bank of San Francisco, Federal Home Loan Bank of San Francisco and Pacific Coast Bankers' Bank aggregating $22,400,000, of which $16,003,000 was outstanding as of March 31, 1998 and $16,004,000 was outstanding as of December 31, 1997. The amount of credit outstanding is primarily due to the Company borrowing against their available line with the Federal Home Loan Bank to purchase securities. Management believes that the Company maintains adequate amounts of liquid assets to meet its liquidity needs. The Company's liquidity might be insufficient if deposit withdrawals were to exceed anticipated levels. Deposit withdrawals can increase if a company experiences financial difficulties or receives adverse publicity for other reasons, or if its pricing, products or services are not competitive with those offered by other institutions. CAPITAL RESOURCES. Capital serves as a source of funds and helps protect depositors against potential losses. The primary source of capital for the Company has been internally generated capital through retained earnings. In 1997, the Company successfully completed a common stock offering which netted the Company approximately $17,951,000 to add to its capital resources. This addition to capital was necessary to maintain favorable capital ratios in light of the Company's purchase of the three branches from Bank of America and to support internal growth on the Company's balance sheet. The Company's shareholders' equity increased by $902,000 or 2% from December 31, 1997 to March 31, 1998. The Company is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate mandatory and possibly additional discretionary actions by the regulators that, if undertaken, could have a material effect on the Company's financial statements. Management believes, as of March 31, 1998, that the Company, the Bank and the Thrift meet all capital requirements to which they are subject. The Company's leverage capital ratio at March 31, 1998 was 8.03% as compared with 8.58% as of December 31, 1997. The Company's total risk based capital ratio at March 31, 1998 was 11.94% as compared to 12.78% as of December 31, 1997. 20 The Company's and Bank's actual capital amounts and ratios and regulatory minimums as of March 31, 1998 are as follows. Minimum For Capital To Be Well Capitalized Dollars in thousands Actual Adequacy Purposes Under Prompt Corrective Action Provisions: - ----------------------------------------------------------------------------------------------------------------------------------- Consolidated Amount Ratio Amount Ratio Amount Ratio - ----------------------------------------------------------------------------------------------------------------------------------- As of March 31, 1998 Total capital (to risk weighted assets) $ 37,131 13.12% $ 22,683 8.0% $ 28,298 10.0% Tier 1 capital (to risk weighted assets) 33,787 11.94 11,319 4.0 16,979 6.0 Leverage ratio* 33,787 8.03 16,840 4.0 21,050 5.0 The Bank: - ----------------------------------------------------------------------------------------------------------------------------------- As of March 31, 1998 Total capital (to risk weighted assets) 29,736 12.06 19,719 8.0 24,649 10.0 Tier 1 capital (to risk weighted assets) 26,649 10.81 9,860 4.0 14,789 6.0 Leverage ratio* $ 26,649 6.98% $ 15,272 4.0% $ 19,090 5.0% - ----------------------------------------------------------------------------------------------------------------------------------- - The leverage ratio consists of Tier 1 capital divided by quarterly average assets. The minimum leverage ratio is 3 percent for banking organizations that do not anticipate significant growth and that have well-diversified risk, excellent asset quality and in general, are considered top-rated banks. Most financial institutions are subject to a minimum leverage ratio of 4% to 5%. The Company has no formal dividend policy, and dividends are issued solely at the discretion of the Company's Board of Directors, subject to compliance with regulatory requirements. In order to pay any cash dividends, the Company must receive payments of dividends or management fees from the Bank or the Thrift. There are certain regulatory limitations on the payment of cash dividends by banks and thrift and loan companies. DEPOSITS. Deposits are the Company's primary source of funds. At March 31, 1998, the Company had a deposit mix of 41% in savings deposits, 28% in time deposits, 14% in interest-bearing checking accounts and 17% in noninterest-bearing demand accounts. Noninterest-bearing demand deposits enhance the Company's net interest income by lowering its costs of funds. The Company obtains deposits primarily from the communities it serves. No material portion of its deposits has been obtained from or is dependent on any one person or industry. The Company's business is not seasonal in nature. The Company accepts deposits in excess of $100,000 from customers. These deposits are priced to remain competitive. At March 31, 1998, the Company had no brokered deposits. In December 1997 the Company acquired three branches of Bank of America. It acquired $60,849,000 in deposits. Deposits in these three acquired branches as of March 31, 1998 were approximately $61,281,000. Maturities of time certificates of deposits of $100,000 or more outstanding at March 31, 1998 and 1997 and December 31, 1997 are summarized as follows: AT MARCH 31, ----------------- 1998 1997 AT DECEMBER 31, 1997 ------ ------ -------------------- (IN THOUSANDS) Three months or less $ 6,366 $ 1,915 $ 8,404 Over three to six months 15,107 7,846 7,799 Over six to twelve months 2,197 2,325 7,870 21 Over twelve months 6,887 2,194 6,188 ------- ------- ------- Total $30,557 $14,280 $30,261 ------- ------- ------- ------- ------- ------- BORROWED FUNDS At March 31 1998, 1997 and 1996 the Company's borrowed funds consisted of the following: YEAR ENDED MARCH 31 DECEMBER 31 -------- ----------- 1998 1997 1997 (Dollars in thousands) Securities sold under agreements to repurchase; dated March 25, 1998; fixed rate of 5.74%; payable on March 25, 1999 $ 2,130 $ 6,953 $ 2,459 Unsecured loan from unaffiliated bank dated July 26, 1996; effective interest rate of 9%; interest payable quarterly at prime + .50%; principal payable quarterly at $135,714; final payment due on April 30 1998 - 330 286 FHLB loan, dated December 18, 1997; effective rate of 5.61%; rate reprices monthly based on the 1 month LIBOR; payable on December 18, 1998 10,900 0 10,900 FHLB loan, dated January 16, 1997; variable rate of 5.68%; rate reprices monthly based on the 1 month LIBOR; payable on January 25, 1999 5,000 5,000 5,000 FHLB loan, dated July 15, 1994; fixed rate of 7.58% payable on July 15, 1999 103 105 104 Short-term note from City Redevelopment Agency dated June 24, 1996; interest free; payable on July 8, 1997 - - - Long-term note from unaffiliated bank dated December 22, 1997; fixed rate of 7.80%; principal and interest payable monthly at $25,047; payments calculated as fully amortizing over 25 years with a 10 year call 3,296 0 3,300 ------- ------- ------- Total $21,429 $12,388 $22,049 ------- ------- ------- ------- ------- ------- The increase in the borrowings are primarily due to the Company borrowing funds from its available lines of credit with the Federal Home Loan Bank to purchase securities and the origination of a loan to assist in financing the new administrative building and main branch. RETURN ON EQUITY AND ASSETS Three months ended Year ended March 31 December 31 --------------------------- ----------- 1998 1997 1997 ---- ---- ---- Return on average assets .78% .76% .13% Return on average equity 8.12% 9.72% 1.46% Dividend payout ratio - - - Average equity to average assets 9.77% 7.90% 8.76% 22 IMPACT OF INFLATION The primary impact of inflation on the Company is its effect on interest rates. The Company's primary source of income is net interest income which is affected by changes in interest rates. The Company attempts to limit inflation's impact on its net interest margin through management of rate sensitive assets and liabilities and the analysis of interest rate sensitivity. The effect of inflation on premises and equipment, as well as on interest expenses, has not been significant for the periods covered in this report. REAL ESTATE DEVELOPMENT ACTIVITIES California law allows state-chartered banks to engage in real estate development activities. The Bank established MAID in 1987 pursuant to this authorization. After changes in federal law effectively required that these activities be divested as prudently as possible but in any event before 1997, MAID reduced its activities and embarked on a plan to liquidate its real estate holdings. In 1995 the uncertainty about the effect of the investment in MAID on the results of future operations caused management to write off its remaining investment of $2,881,000 in real property development. At March 31, 1998, MAID held two real estate projects including improved and unimproved land in various stages of development. MAID continues to develop these projects, and any amounts realized upon sale or other disposition of these assets above their current carrying value of zero will result in noninterest income at the time of such sale or disposition. In the first quarter of 1998, one lot was sold resulting in noninterest income of approximately $22,000. Although the Company expects that sale or disposition of its remaining assets will result in some positive contribution to noninterest income at some time in the future, no assurance can be given as to whether or when such sales or dispositions will be completed or that the amounts, if any, that the Company will ultimately realize on such assets or whether such amounts will exceed the future expenses required to hold and complete development of the projects. The amounts, if any, realized on future disposition of these properties will depend on conditions in the local real estate market and the demand, if any, for new development. The Company's regulatory deadline for completing its divestiture of these assets is December 31, 2000. YEAR 2000 The Company is aware of the issues associated with the programming code in existing computer systems as the millennium (year 2000) approaches. The "year 2000" problem is pervasive and complex as virtually every computer operation will be affected in some way by the rollover of the two digit year value to 00. The issue is whether computer systems will properly recognize date sensitive information when the year changes to 2000. Systems that do not properly recognize such information could generate erroneous data or cause a system to fail. The Company has a year 2000 compliance plan that has been approved by its board of directors. The board of directors is updated monthly on the progress of the plan. The company is utilizing both internal and external resources to identify, correct or reprogram the systems in order that they be year 2000 compliant. The Bank's core banking system, Jack Henry Associates Inc. Silverlake, is anticipating a release in August 1998 that will be year 2000 compliant. This will allow adequate time for testing to be completed by mid 1999. With respect to external systems, the Company is in contact with vendors and customers in order to monitor the progress with year 2000 compliance efforts and assess the need for contingency plans, if applicable. To date, most vendors have provided confirmations that they are either compliant or are making progress toward planned compliance. Although the Bank was approximately four months behind 23 schedule on its year 2000 project as of the time of the examination, as of the date of this report, Management believes they are now on schedule with the project. Based on a preliminary study, the Company expects to spend approximately $250,000 to bring its information systems into year 2000 compliance. A significant proportion of these costs are not likely to be incremental costs to the Company, but rather will represent the redeployment of existing information technology resources. The expenditures in 1997 were negligible. Also see "Memorandum of Understanding" contained herein. MEMORANDUM OF UNDERSTANDING As a result of a joint examination of the Bank conducted as of January 12, 1998 by the Federal Deposit Insurance Corporation (the "FDIC") and the Department of Financial Institutions (the "DFI"), the FDIC and the DFI have indicated that they intend to require the Bank to enter into a Memorandum of Understanding requiring the Bank to do the following: 1) Conduct a comprehensive management review of the Bank's executive management to maintain a management structure suitable to its needs in light of its recent rapid growth. 2) Have and retain qualified management with qualifications and experience commensurate with their duties and responsibilities at the Bank. 3) Develop a plan to reduce the Bank's economic value of equity exposure to loss from interest rate changes to acceptable levels. 4) Formulate, adopt and implement a comprehensive risk management process that will strengthen management expertise and improve securities portfolio management and management information and measurement systems. 5) Establish and maintain an adequate reserve for loan losses and develop and revise, adopt and implement a comprehensive policy to ensure the adequacy of the allowance. 6) Develop, adopt and implement a plan to control overhead and restore the Bank's profitability. 7) Correct deficiencies relating to the year 2000 project. 8) Furnish written progress reports. As of the date of this report, the Memorandum of Understanding was not yet in final form. The Company believes it can comply with the terms of the agreement. A Memorandum of Understanding is an enforceable agreement. Failure to comply with its terms can lead to further enforcement action by bank regulators, including cease-and-desist orders, imposition of a receiver or conservator, termination of deposit insurance, imposition of civil money penalties and removal and prohibition orders against institution-affiliated parties. 24 PART II - OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company is a party to routine litigation in the ordinary course of its business. In the opinion of management, pending and threatened litigation is not likely to have a material adverse effect on the financial condition or results of operations of the Company. Also see "Management's Discussion and Analysis of Financial Condition and Results of Operations - Memorandum of Understanding." contained herein. ITEM 2. CHANGES IN SECURITIES. None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS. No matters were submitted for shareholder vote in the quarter ended March 31, 1998. ITEM 5. OTHER INFORMATION. In the opinion of management, there is no additional information relating to these periods being reported which warrants inclusion in the report. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits. Exhibits Description of Exhibits -------- ----------------------- 3.1 Articles of Incorporation, incorporated by reference * from (filed as Exhibit 3.1 of the Company's September 30, 1996 Form 10Q filed with the SEC on or about November 14, 1996). 3.2 Bylaws (filed as Exhibit 3.2 of the Company's September * 30, 1996 Form 10Q filed with the SEC on or about November 14, 1996.) 10 Employment agreement between Thomas T. Hawker and * Capital Corp. 10.1 Administration Construction Agreement (filed as Exhibit * 10.4 of the Company's 1995 Form 10K filed with the SEC on or about March 31, 1996). 10.2 Stock Option Plan (filed as Exhibit 10.6 of the * Company's 1995 Form 10K filed with the SEC on or about March 31, 1996). 25 10.3 401 (k) Plan (filed as Exhibit 10.7 of the Company's * 1995 Form 10K filed with the SEC on or about March 31, 1996 10.4 Employee Stock Ownership Plan (filed as Exhibit 10.8 of * the Company's 1995 form 10K filed with the SEC on or about March 31, 1996). (b) REPORTS ON FORM 8-K None * DENOTES DOCUMENTS WHICH HAVE BEEN INCORPORATED BY REFERENCE. 26 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated May 14, 1998 CAPITAL CORP OF THE WEST (Registrant) By /s/Thomas T. Hawker ------------------------------- Thomas T. Hawker President and Chief Executive Officer By /s/ Janey E. Boyce ------------------------------- Janey E. Boyce Principal Financial Officer 27