Exhibit 13
Farmers & Merchants
Bancorp
2003
Annual
Report
1
To Our Shareholders:
We are pleased to announce that 2003 was the most profitable and successful
year in the Company's history. The strong results represent the 6th sequential
year and 24th consecutive quarter of improved profit performance over the same
period the prior year. The company's success in 2003 was once again drive by our
longstanding commitment to deliver personalized customer service and reinvest in
the communities we serve. This established trend of improving performance
increasingly evidences the value being created by systematic implementation of
the Long Term Strategic Plan carefully crafted by the Board of Directors and
Executive Management.
For 2003, Farmers & Merchants Bancorp generated net income after tax of
$14,775,000 or $19.30 per share of common stock, an 11.3% increase over the
prior year. Gross loans reached $807 million, up 15.8%, and investment
securities increased 11.9% to $262 million. Total deposits expanded 6.4% to $904
million centered in growth of demand, savings and money market balances. Return
on average assets was 1.36% and return on average equity reached 13.88%, a 37
basis points rise over 2002. In conjunction with the strong results, over
$2,000,000 in capital improvements were completed during 2003. Additionally, the
reserve for future loan losses was increased to $17,220,000 providing the
Company with a strong reserve against the potential financial impacts of future
negative economic events.
Based on the Company's strong performance, the Board of Directors
unanimously approved the 29th consecutive 5% stock dividend last April. In
addition, the Board of Directors a9lso unanimously declared two cash dividends
totaling $4,736,000 or $6.20 per share of common stock. The cash dividends
declared during 2003 represented a 7.5% increase over 2002.
During 2003, we began to evolve our strategic focus from initiatives
designed to modernize the Company's technology and work processes to expansion
of our product lines and delivery capabilities including new branch openings. We
commenced a project to reengineer our Loan Service Center in order to increase
processing volumes and improve customer response times. This effort will include
installation of an advanced automated loan processing system and is expected to
be completed by 3rd quarter 2004.
Last September, we held the grand opening of our new Vintage Faire Branch,
the fourth F&M office in Modesto. Vintage Faire is the first branch to
incorporate our new retail model bank design which features state-of-the-art
customer service technology. The following month, we opened our new Point West
Loan Production Office, located near the Arden Fair Mall in the heart of
Sacramento. Staffed with experienced business lenders, the Point West Office
will focus on expanding F&M's wholesale lending activity in this major
metropolitan market. Additional branch expansions and remodels are planned for
2004. During the second half of the year, we are slated to open a second Galt
office in a new neighborhood shopping center. Negotiations are also underway to
reposition our Westgate Office in order to better service the growth on the west
side of Lodi.
2
During 2004, we expect the Banking Industry will continue to experience a
challenging earnings environment. Many banks' net interest margin will remain
under pressure due to the persistent low market interest rates. The Board of
Directors and Management Team are proactively addressing these challenges by
further improving operating efficiency and enhancing capital and asset/liability
management practices. We believe the geographic territory served by the Company
offers significant growth opportunities and feel the functionality and value of
our products and customer solutions will differentiate Farmers & Merchants
Bancorp from the competition. These advantages in the hands of our talented team
of employees have the potential to build value for our shareholders over time.
We appreciate the significant contributions made by the Board of Directors
during 2003, and wish to acknowledge their ongoing commitment to represent the
shareholder's best interest. Special recognition is also owed to our exceptional
employees for their dedication and tremendous accomplishments this past year.
Their ability to consistently deliver consummate customer service was an
essential ingredient in the creation of shareholder value in 2003.
On behalf of our Board of Directors and all of the F&M employees, thank you
for your confidence and support. We extend our best wishes to you for a healthy
and prosperous 2004.
/s/Kent A. Steinwert /s/Ole R. Mettler
Kent A. Steinwert Ole R. Mettler
President & Chief Executive Officer Chairman of the Board
3
FARMERS & MERCHANTS BANCORP
Mission Statement
Our mission is to become "THE PREMIER" community bank serving the financial
needs of communities throughout California's Great Central Valley. To
successfully accomplish this mission, the Company will:
|X| Consistently provide shareholders with a competitive return on investment.
|X| Strengthen and discipline capital management.
|X| Be staffed by highly skilled and motivated employees, properly supported by
continuing education, advanced technology and quality products.
|X| Carefully target and successfully penetrate desired market segments.
|X| Deliver an extraordinary level of personalized service backed by value
added financial products.
|X| Conservatively manage all risks.
|X| Be exemplary in community development, reinvestment and service.
|X| Develop and foster local ownership in order to maintain independence.
4
FARMERS & MERCHANTS BANCORP
Operating Philosophy
Farmers & Merchants Bancorp was founded, and exists today, for the purpose
of generating a competitive return for it's shareholders through the delivery of
financial services to the communities it serves. In order to accomplish this
purpose, we will strive to benefit four distinct constituents: shareholders,
customers, employees and the communities we serve. Although the short-term
interests of these groups may occasionally differ, in the long run we believe
them to be complimentary. We are convinced that our purpose can only be achieved
through diligent attention to all four. Building the Company's financial
strength by delivering a reliable stream of earnings is fundamental to the
interest of each group. The Company's economic viability has positive
implications for all concerned. We are committed to maintaining the Company's
independence in order to accomplish our purpose of pro-actively benefiting each
constituent.
The Board of Directors and Executive Management Team recognizes that each
constituent has different needs and aspirations, and are committed to the
following goals:
|X| Shareholders, our owners, can expect a competitive return on their
investment, taking into consideration the maintenance of capital adequacy
and capital expenditure requirements. We strive to build their pride of
ownership in an organization respected for it's accomplishments, and
recognized for community leadership.
|X| Customers, whose patronage allows us to function and prosper, are entitled
to financial services of the highest quality, delivered by knowledgeable
and caring employees. Our customers must be assured of a reasonable return
on the deposits entrusted to us, and fair terms on borrowed funds. We
acknowledge that the protection of their deposits, as well as their
personal privacy, are absolute priorities. We will always strive to deliver
a level of service that is "beyond their expectations." Making banking easy
for the customer is a core strategy.
|X| Employees, who are skilled and dedicated, are fundamental to our success.
They can anticipate fair compensation, respect, acknowledgment of superior
performance, a productive and healthy work environment, equal employment
opportunity, and an employer in whom they can take great pride.
|X| The communities we serve can expect a commitment to reinvestment,
leadership in pursuing economic vitality, and an ongoing effort to improve
the overall quality of life. We will be diligent in aiding community based
service organizations through both financial and volunteer support.
5
Report of Management
The management of Farmers & Merchants Bancorp (the Company) and its
subsidiary has the responsibility for the preparation, integrity and reliability
of the consolidated financial statements and related financial information
contained in this annual report. The financial statements were prepared in
accordance with generally accepted accounting principles and prevailing
practices of the banking industry. Where amounts must be based on estimates and
judgments, they represent the best estimates and judgments of management.
Management has established and is responsible for maintaining an adequate
internal control structure designed to provide reasonable, but not absolute,
assurance as to the integrity and reliability of the financial statements,
safeguarding of assets against loss from unauthorized use or disposition and the
prevention and detection of fraudulent financial reporting. The internal control
structure includes: an effective financial accounting environment; a
comprehensive internal audit function; an independent audit committee of the
Board of Directors; and extensive financial and operating policies and
procedures. Management also recognizes its responsibility for fostering a strong
ethical climate which is supported by a code of conduct, appropriate levels of
management authority and responsibility, an effective corporate organizational
structure and appropriate selection and training of personnel.
The Board of Directors, primarily through its audit committee, oversees the
adequacy of the Company's internal control structure. The audit committee, whose
members are neither officers nor employees of the Company, meet periodically
with management, internal auditors and internal credit examiners to review the
functioning of each and to ensure that each is properly discharging its
responsibilities. In addition, PricewaterhouseCoopers LLP, independent auditors,
are engaged to audit the Company's financial statements.
PricewaterhouseCoopers LLP, obtains and maintains an understanding of the
Company's accounting and financial controls and conducts its audit in accordance
with generally accepted auditing standards which includes such audit procedures
as it considers necessary to express the opinion in the report that follows.
Management recognizes that there are inherent limitations in the
effectiveness of any internal control structure. However, management has
assessed and believes that, as of December 31, 2003, the Company's internal
control structure, as described above, provides reasonable assurance as to the
integrity and reliability of the financial statements and related financial
information.
Management also is responsible for compliance with federal and state laws
and regulations concerning loans to insiders and dividend restrictions
designated by the Federal Deposit Insurance Corporation as safety and soundness
laws and regulations.
Management assessed its compliance with the designated laws and regulations
relating to safety and soundness. Based on this assessment, management believes
that the Bank complied with the designated laws and regulations relating to
safety and soundness for the year ended December 31, 2003.
/s/Kent A. Steinwert /s/Stephen W. Haley
Kent A. Steinwert Stephen W. Haley
President & Executive Vice President &
Chief Executive Officer Chief Financial Officer
6
Report of Independent Auditors
To the Board of Directors and
Shareholders of Farmers & Merchants Bancorp:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of income, of changes in shareholders' equity, of
comprehensive income and of cash flows present fairly, in all material respects,
the financial position of Farmers & Merchants Bancorp and its subsidiaries (the
"Company") at December 31, 2003 and 2002, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2003 in conformity with accounting principles generally accepted in the
United States of America. These financial statements are the responsibility of
the Company's management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with auditing standards generally accepted in the
United States of America, which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
/s/ PricewaterhouseCoopers LLP
PricewaterhouseCoopers LLP
February 13, 2004
7
Consolidated Statements of Income
(in thousands except per share data)
Year Ended December 31,
2003 2002 2001
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Interest Income
Interest and Fees on Loans $44,886 $41,911 $43,956
Interest on Federal Funds Sold and Securities Purchased
Under Agreements to Resell 190 555 1,922
Interest on Investment Securities:
Taxable 7,065 9,400 15,112
Tax-Exempt 2,743 2,372 2,540
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Total Interest Income 54,884 54,238 63,530
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Interest Expense
Interest on Deposits 8,115 11,369 21,038
Interest on Borrowed Funds 2,942 2,227 2,242
Interest on Subordinated Debentures 16 - -
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Total Interest Expense 11,073 13,596 23,280
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Net Interest Income 43,811 40,642 40,250
Provision for Loan Losses 625 4,926 1,000
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Net Interest Income After Provision for Loan Losses 43,186 35,716 39,250
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Non-Interest Income
Service Charges on Deposit Accounts 4,892 4,760 4,179
Net Gain on Sale of Investment Securities 935 276 88
Credit Card Merchant Fees 1,658 1,415 1,207
Gain on Sale of Assets - 2,800 -
Increase in Cash Surrender Value of Life Insurance 1,540 1,433 -
Other 3,893 3,182 2,900
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Total Non-Interest Income 12,918 13,866 8,374
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Non-Interest Expense
Salaries and Employee Benefits 21,058 17,796 16,986
Occupancy Expense 1,591 1,709 1,680
Equipment Expense 2,415 2,146 2,026
Other 8,222 7,458 6,794
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Total Non-Interest Expense 33,286 29,109 27,486
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Income Before Income Taxes 22,818 20,473 20,138
Provision for Income Taxes 8,043 7,054 7,821
- -------------------------------------------------------------------------------- ----------- ----------- -----------
Net Income $14,775 $13,419 $12,317
================================================================================ =========== =========== ===========
Earnings Per Share $ 19.30 $ 17.34 $ 15.57
================================================================================ =========== =========== ===========
The accompanying notes are an integral part of these consolidated financial
statements
8
Consolidated Balance Sheets
(in thousands except per share data)
December 31,
Assets 2003 2002
- ---------------------------------------------------------------------------------------- ------------- -------------
Cash and Cash Equivalents:
Cash and Due from Banks $ 35,800 $ 45,389
Federal Funds Sold and Securities Purchased Under Agreements to Resell - 8,185
- ---------------------------------------------------------------------------------------- ------------- -------------
Total Cash and Cash Equivalents 35,800 53,574
- ---------------------------------------------------------------------------------------- ------------- -------------
Investment Securities:
Available-for-Sale 223,965 206,063
Held-to-Maturity 37,957 27,870
- ---------------------------------------------------------------------------------------- ------------- -------------
Total Investment Securities 261,922 233,933
- ---------------------------------------------------------------------------------------- ------------- -------------
Loans: 806,906 696,675
Less: Allowance for Loan Losses 17,220 16,684
- ---------------------------------------------------------------------------------------- ------------- -------------
Loans, Net 789,686 679,991
- ---------------------------------------------------------------------------------------- ------------- -------------
Premises and Equipment, Net 11,209 11,342
Interest Receivable and Other Assets 49,948 43,067
- ---------------------------------------------------------------------------------------- ------------- -------------
Total Assets $1,148,565 $1,021,907
======================================================================================== ============= =============
Liabilities
Deposits:
Demand $ 223,000 $ 205,997
Interest-Bearing Transaction Accounts 96,869 93,646
Savings 276,016 231,964
Time 308,464 318,618
- ---------------------------------------------------------------------------------------- ------------- -------------
Total Deposits 904,349 850,225
- ---------------------------------------------------------------------------------------- ------------- -------------
Federal Funds Purchased 1,000 16,997
Federal Home Loan Bank Advances 111,928 40,965
Subordinated Debentures 10,310 -
Interest Payable and Other Liabilities 11,373 10,155
- ---------------------------------------------------------------------------------------- ------------- -------------
Total Liabilities 1,038,960 918,342
- ---------------------------------------------------------------------------------------- ------------- -------------
Shareholders' Equity
Preferred Stock: No Par Value. 1,000,000 Authorized, None Issued or Outstanding - -
Common Stock: Par Value $0.01, 2,000,000 Shares Authorized, 763,274 and
769,006 Issued and Outstanding at December 31, 2003 and 2002, Respectively 8 7
Additional Paid-In Capital 72,506 64,979
Retained Earnings 37,650 36,749
Accumulated Other Comprehensive (Loss) Income (559) 1,830
- ---------------------------------------------------------------------------------------- ------------- -------------
Total Shareholders' Equity 109,605 103,565
- ---------------------------------------------------------------------------------------- ------------- -------------
Total Liabilities and Shareholders' Equity $1,148,565 $1,021,907
======================================================================================== ============= =============
The accompanying notes are an integral part of these consolidated financial
statements
9
Consolidated Statements of Changes in Shareholders' Equity
(in thousands except per share data)
Accumulated
Common Additional Other Total
Shares Common Paid-In Retained Comprehensive Shareholders'
Outstanding Stock Capital Earnings Income(Loss) Equity
- --------------------------------------------------------- --------- ------------- ----------- ------------------- -----------------
Balance, December 31, 2000 687,491 $ 7 $53,559 $36,527 $790 $90,883
- --------------------------------------------------------- --------- ------------- ----------- ------------------- -----------------
Net Income 12,317 12,317
Cash Dividends Declared on
Common Stock (3,923) (3,923)
5% Stock Dividend 33,831 8,289 (8,289) -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (133) (133)
Redemption of Stock (2,053) (488) (488)
Change in Net Unrealized Gain on
Securities Available-for-Sale 2,080 2,080
- --------------------------------------------------------- --------- ------------- ----------- ------------------- -----------------
Balance, December 31, 2001 719,269 $ 7 $61,360 $36,499 $ 2,870 $100,736
- --------------------------------------------------------- --------- ------------- ----------- ------------------- -----------------
Net Income 13,419 13,419
Cash Dividends Declared on
Common Stock (4,404) (4,404)
5% Stock Dividend 34,501 8,625 (8,625) -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (140) (140)
Redemption of Stock (20,749) (5,006) (5,006)
Unrealized Gains on Derivative Instruments 117 117
Minimum Pension Plan Liability Adjustment (731) (731)
Change in Net Unrealized Loss on
Securities Available-for-Sale (426) (426)
- --------------------------------------------------------- --------- ------------- ----------- ------------------- -----------------
Balance, December 31, 2002 733,021 $ 7 $64,979 $36,749 $ 1,830 $103,565
- --------------------------------------------------------- --------- ------------- ----------- ------------------- -----------------
Net Income 14,775 14,775
Cash Dividends Declared on
Common Stock (4,736) (4,736)
5% Stock Dividend 35,985 1 8,995 (8,996) -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend (142) (142)
Redemption of Stock (5,732) (1,468) (1,468)
Change in Net Unrealized Gains on
Derivative Instruments (29) (29)
Minimum Pension Plan Liability Adjustment (1,257) (1,257)
Change in Net Unrealized Loss on
Securities Available-for-Sale (1,103) (1,103)
- --------------------------------------------------------- --------- ------------- ----------- ------------------- -----------------
Balance, December 31, 2003 763,274 $ 8 $72,506 $37,650 $ (559) $109,605
========================================================= ========= ============= =========== =================== =================
The accompanying notes are an integral part of these consolidated financial
statements
10
Consolidated Statements of Comprehensive Income
(in thousands)
Year Ended December 31,
2003 2002 2001
- ------------------------------------------------------------------------------------------- ----------- ---------- ------------
Net Income $14,775 $13,419 $12,317
Other Comprehensive (Loss) Income
Unrealized (Losses) Gains on Derivative Instruments:
Unrealized holding (losses) gains arising during the period, net of income tax effects
of $(21) and $85 for the years ended December 31, 2003 and 2002, respectively. (29) 117 -
Unrealized Loss on Minimum Pension Liability Adjustment:
Unrealized loss arising during the period, net of income tax effects of
$(910) and $(531) for the years ended December 31, 2003 and 2002, respectively. (1,257) (731) -
Unrealized (Losses) Gains on Securities:
Unrealized holding (losses) gains arising during the period, net of income tax
effects of $(480), $(117) and $1,492 for the
years ended December 31, 2003, 2002 and 2001, respectively. (662) (266) 2,131
Less: Reclassification adjustment for realized gains
included in net income, net of related income tax effects
of $(320), $(116) and $(37) for the years ended December 31,
2003, 2002 and 2001, respectively. (441) (160) (51)
- ------------------------------------------------------------------------------------------- ----------- ---------- ------------
Total Other Comprehensive (Loss) Income (2,389) (1,040) 2,080
- ------------------------------------------------------------------------------------------- ----------- ---------- ------------
Comprehensive Income $12,386 $12,379 $14,397
=========================================================================================== =========== ========== ============
The accompanying notes are an integral part of these consolidated financial
statements
11
Consolidated Statements of Cash Flows
(in thousands)
Year Ended December 31,
2003 2002 2001
- -------------------------------------------------------------------------------- ------------- ------------- -------------
Operating Activities
Net Income $ 14,775 $ 13,419 $ 12,317
Adjustments to Reconcile Net Income to Net Cash Provided
by Operating Activities:
Provision for Loan Losses 625 4,926 1,000
Depreciation and Amortization 1,554 1,584 1,592
Provision for Deferred Income Taxes (727) (836) (38)
Net Amortization of Investment Security Premium & Discounts 1,725 10 (314)
Net Gain on Sale of Investment Securities (935) (276) (88)
Net Increase in Interest Receivable and Other Assets (1,874) (865) (307)
Net (Decrease) Increase in Interest Payable and Other Liabilities (949) (12) 479
- -------------------------------------------------------------------------------- ------------- ------------- -------------
Net Cash Provided by Operating Activities 14,194 17,950 14,641
- -------------------------------------------------------------------------------- ------------- ------------- -------------
Investing Activities
Securities Available-for-Sale:
Purchased (217,309) (113,687) (26,704)
Sold or Matured 196,640 150,026 66,548
Securities Held-to-Maturity:
Purchased (22,340) (329) (6,460)
Matured 12,328 5,214 15,142
Purchase of Life Insurance Contracts (2,600) (10,080) (18,000)
Net Increase in Loans (110,928) (95,792) (105,526)
Principal Collected on Loans Previously Charged Off 608 335 587
Net Additions to Premises and Equipment (1,421) (1,495) (1,468)
- -------------------------------------------------------------------------------- ------------- ------------- -------------
Net Cash Used for Investing Activities (145,022) (65,808) (75,881)
- -------------------------------------------------------------------------------- ------------- ------------- -------------
Financing Activities
Net Increase in Demand, Interest-Bearing Transaction,
and Savings Accounts 64,278 34,066 57,351
Net Decrease in Time Deposits (10,154) (3,552) (2,318)
Net (Decrease) Increase in Federal Funds Purchased (15,997) 16,997 -
Net Increase (Decrease) in Federal Home Loan Bank Advances
Advances 71,000 - -
Paydowns (37) (35) (33)
Subordinated Debentures 10,310 - -
Stock Redemption (1,468) (5,006) (488)
Cash Dividends (4,878) (4,544) (4,056)
- -------------------------------------------------------------------------------- ------------- ------------- -------------
Net Cash Provided by Financing Activities 113,054 37,926 50,456
- -------------------------------------------------------------------------------- ------------- ------------- -------------
Decrease in Cash and Cash Equivalents (17,774) (9,932) (10,784)
Cash and Cash Equivalents at Beginning of Year 53,574 63,506 74,290
- -------------------------------------------------------------------------------- ------------- ------------- -------------
Cash and Cash Equivalents at End of Year $35,800 $53,574 $63,506
================================================================================ ============= ============= =============
Supplementary Data
Cash Payments made for Income Taxes $ 8,050 $ 7,200 $ 8,125
Interest Paid $11,475 $14,260 $22,995
================================================================================ ============= ============= =============
The accompanying notes are an integral part of these consolidated financial
statements
12
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
Farmers & Merchants Bancorp (the Company) was organized March 10, 1999. Primary
operations are related to traditional banking activities through its subsidiary
Farmers & Merchants Bank of Central California (the Bank). The consolidated
financial statements of the Company and its subsidiary, the Bank, are prepared
in conformity with generally accepted accounting principles and prevailing
practices within the banking industry. In preparing the financial statements,
management is required to make estimates and assumptions that affect reported
amounts as of the date of the balance sheet and revenues and expenses for the
period. These estimates are based on information available as of the date of the
financial statements. Therefore, actual results could differ from those
estimates. The following is a summary of the significant accounting and
reporting policies used in preparing the consolidated financial statements.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the
Company and the Company's wholly owned subsidiaries, F & M Bancorp, Inc. and the
Bank, along with the Bank's wholly owned subsidiaries, Farmers & Merchants
Investment Corporation and Farmers/Merchants Corp. The investment in the Bank is
carried at the Company's equity in the underlying net assets. Significant
intercompany transactions have been eliminated in consolidation. F & M Bancorp,
Inc. was created in March 2002 to protect the name F & M Bank, Farmers &
Merchants Investment Corporation has been dormant since 1991. Farmers/Merchants
Corp. acts as trustee on deeds of trust originated by the Bank. In December
2003, the Company formed a wholly owned subsidiary, FMCB Statutory Trust I. FMCB
Statutory Trust I, is a non-consolidated subsidiary per generally accepted
accounting principals (GAAP), and was formed for the sole purpose of issuing
Trust Preferred Securities.
Certain amounts in the prior years' financial statements and related footnote
disclosures have been reclassified to conform to the current-year presentation.
These reclassifications have no effect on previously reported income.
Cash and Cash Equivalents
For purposes of the Consolidated Statements of Cash Flows, the Company has
defined cash and cash equivalents as those amounts included in the balance sheet
captions Cash and Due from Banks and Federal Funds Sold and Securities Purchased
Under Agreements to Resell. Generally, these transactions are for one-day
periods. For these instruments, the carrying amount is a reasonable estimate of
fair value.
Investment Securities
Investment securities are classified at the time of purchase as held-to-maturity
if it is management's intent and the Company has the ability to hold the
securities until maturity. These securities are carried at cost, adjusted for
amortization of premium and accretion of discount using a methodology which
approximates a level yield of interest over the estimated remaining period until
maturity. Losses, reflecting a decline in value judged by the Company to be
other than temporary, are recognized in the period in which they become known.
Securities are classified as available-for-sale if it is management's intent, at
the time of purchase, to hold the securities for an indefinite period of time
and/or to use the securities as part of the Company's asset/liability management
strategy. Securities classified as available-for-sale include securities which
may be sold to effectively manage interest rate risk exposure, prepayment risk,
satisfy liquidity demands and other factors. These securities are reported at
fair value with aggregate, unrealized gains or losses excluded from income and
included as a separate component of shareholders' equity, net of related income
taxes. Fair values are based on quoted market prices or broker/dealer price
quotations on a specific identification basis. Gains or losses on the sale of
these securities are computed using the specific identification method.
Unrealized losses on these securities, reflecting a decline in value judged by
the Company to be other than temporary, are recognized in the period in which
they become known.
Trading securities, if any, are acquired for short-term appreciation and are
recorded in a trading portfolio and are carried at fair value, with unrealized
gains and losses recorded in non-interest income.
Loans
Loans are reported at the principal amount outstanding net of unearned discounts
and deferred loan fees. Interest income on loans is accrued daily on the
outstanding balances using the simple interest method. Loan origination fees are
deferred and recognized over the contractual life of the loan as an adjustment
to the yield. Loans are placed on a non-accrual status when the collection of
principal or interest is in doubt or when they become past due for 90 days or
13
more unless they are both well-secured and in the process of collection. For
this purpose a loan is considered well-secured if it is collateralized by
property having a net realizable value in excess of the amount of the loan or is
guaranteed by a financially capable party. When a loan is placed on non-accrual
status, the accrued and unpaid interest receivable is reversed and charged
against current income, thereafter, interest income is recognized only as it is
collected in cash. Loans placed on a non-accrual status are returned to accrual
status when the loans are paid current as to principal and interest and future
payments are expected to be made in accordance with the contractual terms of the
loan.
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheets is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate or on the observable or estimated market price of the loan or the fair
value of the collateral if the loan is collateral dependent. Impaired loans are
placed on a non-accrual status with income reported accordingly. Cash payments
are first applied as a reduction of the principal balance until collection of
the remaining principal and interest can be reasonably assured. Thereafter,
interest income is recognized as it is collected in cash.
Allowance for Loan Losses
As a financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, the allowance for
loan losses is maintained at a level considered adequate by management to
provide for losses that can be reasonably anticipated. The allowance is
increased by provisions charged to operating expense and reduced by net
charge-offs. Management employs a systematic methodology for determining the
allowance for loan losses. On a quarterly basis, management reviews the credit
quality of the loan portfolio and considers problem loans, delinquencies,
internal credit reviews, current economic conditions, loan loss experience and
other factors in determining the adequacy of the allowance balance.
The conditions evaluated in connection with the allowance may include existing
general economic and business conditions affecting the key lending areas of the
Company, credit quality trends, collateral values, loan volumes and
concentration, seasoning of the loan portfolio, specific industry conditions,
recent loss experience, duration of the current business cycle, bank regulatory
examination results and findings of the Company's internal credit examiners.
The allowance also incorporates the results of measuring impaired loans as
provided in Statement of Financial Accounting Standards (SFAS) No. 114,
"Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting
by Creditors for Impairment of a Loan-Income Recognition and Disclosures". These
accounting standards prescribe the measurement methods, income recognition and
disclosures related to impaired loans, which are discussed more fully in Note 4.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may vary
from current estimates. The estimates are reviewed periodically and, as
adjustments become necessary, are reported in earnings in the periods in which
they become known.
Premises and Equipment
Premises, equipment and leasehold improvements are stated at cost, less
accumulated depreciation and amortization. Depreciation is computed principally
by the straight line method over the estimated useful lives of the assets.
Estimated useful lives of buildings range from 30 to 40 years, and for furniture
and equipment from 3 to 8 years. Leasehold improvements are amortized over the
lesser of the terms of the respective leases, or their useful lives, which are
generally 5 to 10 years. Remodeling and capital improvements are capitalized
while maintenance and repairs are charged directly to occupancy expense.
Other Real Estate
Other real estate owned, which is included in other assets, is comprised of
properties acquired through foreclosures in satisfaction of indebtedness. These
properties are recorded at fair value less estimated selling costs upon
acquisition. Revised estimates to the fair value less cost to sell are reported
as adjustments to the carrying amount of the asset, provided that such adjusted
value is not in excess of the carrying amount at acquisition. Initial losses on
properties acquired through full or partial satisfaction of debt are treated as
credit losses and charged to the Allowance for Loan Losses at the time of
acquisition. Subsequent declines in value from the recorded amounts, routine
holding costs, and gains or losses upon disposition, if any, are included in
non-interest income or expense as incurred.
14
Income Taxes
As required, the Company uses the liability method of accounting for income
taxes. This method results in the recognition of deferred tax assets and
liabilities that are reflected at currently enacted income tax rates applicable
to the period in which the deferred tax assets or liabilities are expected to be
realized or settled. As changes in tax laws or rates are enacted, deferred tax
assets and liabilities are adjusted through the provision for income taxes. The
deferred provision for income taxes is the result of the net change in the
deferred tax asset and deferred tax liability balances during the year. This
amount combined with the current taxes payable or refundable results in the
income tax expense for the current year.
Earnings Per Share
Earnings per share amounts are computed by dividing net income by the weighted
average number of common shares outstanding for the period. The weighted average
number of shares outstanding as of December 31, 2003, 2002 and 2001 were
765,433, 774,066 and 791,125. Prior years have been restated for the 5% stock
dividend paid in each of the years presented.
Segment Reporting
The Statement of Financial Accounting Standards No. 131, "Disclosures about
Segments of an Enterprise and Related Information" requires that public
companies report certain information about operating segments. It also requires
that public companies report certain information about their products and
services, the geographic areas in which they operate, and their major customers.
The Company is a community bank which offers a wide array of products and
services to its customers. Pursuant to its banking strategy, emphasis is placed
on building relationships with its customers, as opposed to building specific
lines of business. As a result, the Company is not organized around discernable
lines of business and prefers to work as an integrated unit to customize
solutions for its customers, with business line emphasis and product offerings
changing over time as needs and demands change. Thus, all necessary requirements
of SFAS No. 131 have been met by the Company as of December 31, 2003.
Derivative Instruments and Hedging Activities
The Statement of Financial Accounting Standards, No. 133, "Accounting for
Derivative Instruments and Certain Hedging Activities" as amended by the
Statement of Financial Accounting Standards, No. 138, establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. All
derivatives, whether designated in hedging relationships or not, are required to
be recorded on the balance sheet at fair value. Changes in the fair value of
those derivatives are accounted for depending on the intended use of the
derivative and the resulting designation under specified criteria. If the
derivative is designated as a fair value hedge, the changes in the fair value of
the derivative and of the hedged item attributable to the hedged risk are
recognized in earnings. If the derivative is designated as a cash flow hedge,
designed to minimize interest rate risk, the effective portions of the change in
the fair value of the derivative are recorded in other comprehensive income.
Ineffective portions of changes in the fair value of cash flow hedges are
recognized in earnings. As required, SFAS No. 133 was adopted by the Company
effective January 1, 2001.
The Company utilizes derivative financial instruments such as interest rate
caps, floors, swaps and collars. These instruments are purchased and/or sold to
reduce the Company's exposure to changing interest rates. The Company marks to
market the value of its derivative financial instruments and reflects gain or
loss in earnings in the period of change or in other comprehensive income.
Comprehensive Income
The Statement of Financial Accounting Standards, "Reporting Comprehensive
Income" establishes standards for the reporting and display of comprehensive
income and its components in the financial statements. Other comprehensive
income refers to revenues, expenses, gains and losses that generally accepted
accounting principles recognize as changes in value to an enterprise but are
excluded from net income. For the Company, comprehensive income includes net
income (loss) and changes in fair value of its available-for-sale investment
securities, minimum pension liability adjustments and cash flow hedges.
2. SECURITIES PURCHASED UNDER AGREEMENTS TO RESELL
The Company enters into purchases and sales of securities under agreements to
resell substantially identical securities. These types of security transactions
are generally for one day periods and are primarily whole loan securities rated
AA or better. During 2003 and 2002, the underlying securities purchased under
resale agreements were delivered into the Bank's account at a third-party
custodian that recognizes the Company's rights and interest in these securities.
15
3. INVESTMENT SECURITIES
The amortized cost, fair values and unrealized gains and losses of the
securities available-for-sale are as follows:
(in thousands)
Amortized Gross Unrealized Fair/Book
--------------------
December 31, 2003 Cost Gains Losses Value
- --------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $75,842 $ 631 $ 75 $76,398
Obligations of States and Political Subdivisions 27,850 965 21 28,794
Mortgage-Backed Securities 108,661 600 308 108,953
Other 9,296 524 - 9,820
- --------------------------------------------------------------------------------------------------------------------
Total $221,649 $2,720 $ 404 $223,965
====================================================================================================================
Amortized Gross Unrealized Fair/Book
--------------------
December 31, 2002 Cost Gains Losses Value
------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $26,584 $ 400 $ - $26,984
Obligations of States and Political Subdivisions 33,372 1,023 43 34,352
Mortgage-Backed Securities 114,878 2,457 - 117,335
Corporate Bonds 17,579 124 - 17,703
Other 9,432 257 - 9,689
- --------------------------------------------------------------------------------------------------------------------
Total $201,845 $4,261 $ 43 $206,063
====================================================================================================================
The book values, estimated fair values and unrealized gains and losses of
investments classified as held-to-maturity are as follows: (in thousands)
Book Gross Unrealized Fair
---------------------
December 31, 2003 Value Gains Losses Value
- --------------------------------------------------------------------------------------------------------------------
Obligations of States and Political Subdivisions $ 37,582 $ 924 $ 167 $38,339
Other 375 25 - 400
- --------------------------------------------------------------------------------------------------------------------
Total $ 37,957 $ 949 $ 167 $38,739
====================================================================================================================
Book Gross Unrealized Fair
---------------------
December 31, 2002 Value Gains Losses Value
- --------------------------------------------------------------------------------------------------------------------
Obligations of States and Political Subdivisions $ 27,351 $1,230 $ 2 $ 28,579
Other 519 13 - 532
- --------------------------------------------------------------------------------------------------------------------
Total $ 27,870 $1,243 $ 2 $ 29,111
====================================================================================================================
Fair values are based on quoted market prices or dealer quotes. If a quoted
market price is not available, fair value is estimated using quoted market
prices for similar securities.
16
The remaining principal maturities of debt securities as of December 31, 2003
and 2002 are shown below. Mortgage-Backed Securities are presented below based
on expected maturities. Expected maturities may differ from contractual
maturities as borrowers may have the right to call or prepay obligations with or
without call or prepayment penalties.
After 1 After 5 Total
Securities Available-for-Sale Within but but Over Fair
December 31, 2003 (in thousands) 1 Year Within 5 Within 10 10 years Value
------------------------------------------------------------------------------------------------------------------
Securities of U.S. Government Agencies $ 15,021 $61,377 $ - $ - $76,398
Obligations of States and Political Subdivisions 6,066 20,577 1,193 958 28,794
Mortgage-Backed Securities 3,212 90,817 14,924 108,953
Other 9,820 - - - 9,820
------------------------------------------------------------------------------------------------------------------
Total $ 34,119 $172,771 $16,117 $ 958 $223,965
==================================================================================================================
After 1 After 5 Total
Securities Held-to-Maturity Within but but Over Book
December 31, 2003 (in thousands) 1 Year Within 5 Within 10 10 years Value
------------------------------------------------------------------------------------------------------------------
Obligations of States and Political Subdivisions $ 6,147 $ 17,784 $ 11,402 $2,249 $ 37,582
Other - - - 375 375
------------------------------------------------------------------------------------------------------------------
Total $ 6,147 $ 17,784 $ 11,402 $2,624 $ 37,957
==================================================================================================================
Proceeds from sales of securities available-for-sale were as follows:
(in thousands) Gross Gross Gross
Proceeds Gains Losses
- --------------------------------------- ----------- ------------ ---------
2003 $65,406 $1,096 $161
2002 24,862 276 -
2001 5,206 88 -
As of December 31, 2003, securities carried at $111,400,000 were pledged to
secure public and other deposits as required by law. This amount at December 31,
2002 was $105,949,000.
4. LOANS AND ALLOWANCE FOR LOAN LOSSES
Loans as of December 31, consisted of the following:
(in thousands) 2003 2002
- -------------------------------------------------------------------------------
Real Estate $386,735 $322,074
Real Estate Construction 77,115 66,467
Home Equity 55,827 45,150
Agricultural 134,862 109,130
Commercial 136,955 135,877
Consumer 17,504 19,995
- -------------------------------------------------------------------------------
808,998 698,693
Less: Unearned Income on Loans (2,092) (2,018)
- -------------------------------------------------------------------------------
Total Loans $806,906 $696,675
===============================================================================
Non-Accrual Loans $ 2,367 $ 2,897
===============================================================================
17
Changes in the allowance for loan losses consisted of the following:
(in thousands)
2003 2002 2001
- --------------------------------------------------------------------------------
Balance, January 1 $16,684 $12,709 $11,876
Provision Charged to Operating Expense 625 4,926 1,000
Recoveries of Loans Previously Charged Off 608 335 587
Loans Charged Off (697) (1,286) (754)
- --------------------------------------------------------------------------------
Balance, December 31 $17,220 $16,684 $12,709
================================================================================
All impaired loans have been assigned a related allowance for credit losses. As
of December 31, 2003 and 2002, the total recorded investment in impaired loans
was $2,367,000 and $2,897,000, respectively. The related allowance for impaired
loans was $861,000 and $1,289,000 for the years ended 2003 and 2002,
respectively. The average balance of impaired loans was $3.0 million, $4.7
million and $1.1 million for the years ended 2003, 2002 and 2001, respectively.
There was no interest income reported on impaired loans in 2003, 2002 and 2001.
Interest income forgone on loans placed on nonaccrual status was $356,000,
$331,000 and $26,000 for the years ended December 31, 2003, 2002 and 2001,
respectively. Pledged loans totaling $275,055,000 were used to secure Federal
Home Loan Bank advances of $71,000,000 and the unused commitments.
5. PREMISES AND EQUIPMENT
Premises and equipment as of December 31, consisted of the following:
(in thousands) 2003 2002
- -------------------------------------------------------------------------
Land and Buildings $16,535 $16,023
Furniture, Fixtures and Equipment 14,481 15,464
Leasehold Improvements 1,064 1,062
- -------------------------------------------------------------------------
32,080 32,549
Less: Accumulated Depreciation and Amortization 20,871 21,207
- -------------------------------------------------------------------------
Total $11,209 $11,342
=========================================================================
Depreciation and amortization on premises and equipment included in occupancy
and equipment expense amounted to $1,554,000, $1,585,000 and $1,592,000 for the
years ended December 31, 2003, 2002 and 2001, respectively. Total rental expense
for premises were $255,000, $248,000 and $212,000 for the years ended December
31, 2003, 2002 and 2001, respectively. Rental income was $81,000, $73,000 and
$70,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
6. OTHER REAL ESTATE
The Bank reported no other real estate at December 31, 2003 and 2002. Other real
estate includes property no longer utilized for business operations and property
acquired through foreclosure proceedings. These properties are carried at the
lower of cost or estimated net realizable value determined at the date acquired.
Losses arising from the acquisition of these properties are charged against the
allowance for loan losses. Subsequent declines in value, routine holding costs
and net gains or losses on disposition are included in other operating expense
as incurred.
7. TIME DEPOSITS
Time Deposits of $100,000 or more were as follows:
(in thousands)
December 31,
2003 2002
- -----------------------------------------------------------------
Balance $156,586 $148,005
=================================================================
18
At December 31, 2003, the scheduled maturities of time deposits were as follows:
Scheduled
(in thousands) Maturities
- -------------------------------------------------------------------------------
2004 $267,942
2005 19,022
2006 21,500
2007 -
2008 -
Thereafter -
- -------------------------------------------------------------------------------
Total $308,464
===============================================================================
8. INCOME TAXES
Current and deferred income tax expense (benefit) provided for the years ended
December 31, consisted of the following:
(in thousands) 2003 2002 2001
-----------------------------------------------------------------------
Current
Federal $6,235 $5,506 $5,673
State 2,535 2,384 2,186
-----------------------------------------------------------------------
Total Current 8,770 7,890 7,859
-----------------------------------------------------------------------
Deferred
Federal (493) (503) (33)
State (234) (333) ( 5)
-----------------------------------------------------------------------
Total Deferred (727) (836) (38)
-----------------------------------------------------------------------
Total Provision for Taxes $8,043 $7,054 $7,821
=======================================================================
The total provision for income taxes differs from the federal statutory rate as
follows: (in thousands)
2003 2002 2001
Amount Rate Amount Rate Amount Rate
- -------------------------------------------------------------------------------------------------------------------
Tax Provision at Federal Statutory Rate $7,986 35.0 % $7,165 35.0 % $7,048 35.0 %
Interest on Obligations of States
and Political Subdivisions
Exempt from Federal Taxation (933) (4.0)% (806) (3.9)% (658) (3.3)%
State and Local Income Taxes,
Net of Federal Income Tax Benefit 1,496 6.5 % 1,333 6.5 % 1,418 7.0 %
Bank Owned Life Insurance (576) (2.5)% (523) (2.6)% - -
Other, Net 70 0.0 % (115) (0.6)% 13 0.1 %
- -------------------------------------------------------------------------------------------------------------------
Total Provision for Taxes $8,043 35.0 % $7,054 34.4 % $7,821 38.8 %
===================================================================================================================
19
The components of the net deferred tax assets as of December 31 are as follows:
(in thousands) 2003 2002
- -------------------------------------------------------------------------------------------------------------------
Deferred Tax Assets
Allowance for Loan Losses $ 7,240 $7,015
Accrued Liabilities 391 507
Deferred Compensation 1,320 1,160
Unrealized Loss on Minimum Pension Liability 1,441 531
State Franchise Tax 887 834
Interest on Non-Accrual Loans 150 80
- -------------------------------------------------------------------------------------------------------------------
Total Deferred Tax Assets 11,429 10,127
- -------------------------------------------------------------------------------------------------------------------
Deferred Tax Liabilities
Depreciation (401) (214)
Unrealized Gain on Securities Available-for-Sale (974) (1,774)
Securities Accretion (636) (933)
Pension (857) (1,079)
Other (250) (253)
- -------------------------------------------------------------------------------------------------------------------
Total Deferred Tax Liabilities (3,118) (4,253)
- -------------------------------------------------------------------------------------------------------------------
Net Deferred Tax Assets $8,311 $5,874
===================================================================================================================
The net deferred tax assets are reported in Interest Receivable and Other Assets
on the Company's Consolidated Balance Sheets.
9. SHORT TERM BORROWINGS
As of December 31, 2003 and 2002, the Company had unused lines of credit
available for short term liquidity purposes of $370 million and $284 million,
respectively. Federal Funds purchased and advances from the Federal Reserve Bank
are generally issued on an overnight basis.
10. FEDERAL HOME LOAN BANK ADVANCES
The Company's advances from the Federal Home Loan Bank of San Francisco consist
of the following as of December 31,
(in thousands) 2003 2002
- -------------------------------------------------------------------------------------------------------------------
5.35% note payable due February 4, 2008 with interest due quarterly, callable February 2, $25,000 $25,000
2003 and quarterly thereafter.
5.38% note payable due August 12, 2008 with interest due quarterly, callable August 12, 15,000 15,000
2003 and quarterly thereafter.
5.60% amortizing note, interest and principal payable monthly with final maturity of 928 965
September 25, 2018.
1.13% fixed rate credit advance, interest payable monthly with a maturity of February 2, 71,000 -
2004.
- -------------------------------------------------------------------------------------------------------------------
Total $111,928 $40,965
===================================================================================================================
In accordance with the Collateral Pledge and Security Agreement, advances are
secured by all Federal Home Loan Bank stock held by the Company and by agency
and mortgage-backed securities, classified as available-for-sale, with carrying
values of $42,278,913. Pledged loans totaling $275,055,000 were used to secure
Federal Home Loan Bank advances of $71,000,000 and the unused commitments.
11. SHAREHOLDERS' EQUITY
Beginning in 1975 and continuing through 2003, the Company has issued an annual
5% stock dividend. Earnings per share amounts have been restated for each year
presented to reflect the stock dividend.
Dividends from the Bank constitute the principal source of cash to the Company.
The Company is a legal entity separate and distinct from the Bank. Under
regulations controlling California state chartered banks, the Bank is, to some
extent, limited in the amount of dividends that can be paid to shareholders
without prior approval of the State Department of Financial Institutions. These
regulations require approval if total dividends declared by a state chartered
bank in any calendar year exceed the bank's net profits for that year combined
with its retained net profits for the preceding two calendar years. As of
December 31, 2003, the Bank could declare dividends of $20,840,000 without
approval of the California State Banking Department. These regulations apply to
all California state chartered banks.
20
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly discretionary, actions
by regulators that, if undertaken, could have a direct material effect on the
Company and the Bank's financial statements. Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the
Bank must meet specific capital guidelines that involve quantitative measures of
the Company and the Bank's assets, liabilities, and certain off-balance-sheet
items as calculated under regulatory accounting practices. The Company and the
Bank's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios set
forth in the table below of Total and Tier I capital (as defined in the
regulations) to risk-weighted assets (as defined in the regulations), and of
Tier I capital (as defined in the regulations) to average assets (as defined in
the regulations). Management believes, as of December 31, 2003, that the Company
and the Bank meet all capital adequacy requirements to which they are subject.
As of September 30, 2003, the most recent notification from the Federal Reserve
Bank categorized the Company and the Bank as well capitalized under the
regulatory framework for prompt corrective action. To be categorized as well
capitalized, the Company and the Bank must maintain minimum Total risk-based,
Tier I risk-based, Tier I leverage ratios as set forth in the table below. There
are no conditions or events since that notification that management believes
have changed the institutions' categories.
Well Capitalized
Regulatory Capital Under Prompt
(in thousands) Actual Requirements Corrective Action
December 31, 2003 Amount Ratio Amount Ratio Amount Ratio
- --------------------------------------------------------------------------------------------------------------------
Total Bank Capital to Risk Weighted Assets $123,825 12.39% $79,966 8.0% $99,958 10.0%
Total Consolidated Capital to Risk Weighted Assets $132,751 13.24% $80,189 8.0% N/A N/A
Tier I Bank Capital to Risk Weighted Assets $111,272 11.13% $39,983 4.0% $59,975 6.0%
Tier I Consolidated Capital to Risk Weighted Assets $120,164 11.99% $40,095 4.0% N/A N/A
Tier I Bank Capital to Average Assets $111,272 9.91% $44,908 4.0% $56,135 5.0%
Tier I Consolidated Capital to Average Assets $120,164 10.67% $45,036 4.0% N/A N/A
December 31, 2002 Amount Ratio Amount Ratio Amount Ratio
- --------------------------------------------------------------------------------------------------------------------
Total Bank Capital to Risk Weighted Assets $108,191 11.73% $73,766 8.0% $92,208 10.0%
Total Consolidated Capital to Risk Weighted Assets $113,370 12.25% $74,058 8.0% N/A N/A
Tier I Bank Capital to Risk Weighted Assets $ 96,602 10.48% $36,883 4.0% $55,325 6.0%
Tier I Consolidated Capital to Risk Weighted Assets $101,735 10.99% $37,029 4.0% N/A N/A
Tier I Bank Capital to Average Assets $ 96,602 9.84% $39,259 4.0% $49,074 5.0%
Tier I Consolidated Capital to Average Assets $101,735 10.32% $39,439 4.0% N/A N/A
12. EMPLOYEE BENEFIT PLANS
The Company, through the Bank, sponsors a defined benefit Pension Plan (the
Plan) that covers employees of Farmers & Merchants Bank of Central California.
Effective June 9, 2001 the Plan was amended to freeze the benefit accruals in
the Plan. With the exception of employees who had reached age 55 and who had
accumulated 10 years of Plan service, the effect of the amendment was to freeze
the participants' monthly pension benefit. Employees who had reached age 55 and
had accumulated 10 years of Plan service as of December 31, 2000 will continue
to accrue benefits under the Plan. The Bank uses a December 31 measurement date
for the Plan.
The Plan provides benefits, up to a maximum stated in the Plan, based on each
covered employee's years of service and highest five-year average compensation
earned while a participant in the Plan. Plan benefits are fully vested after
five years of Plan service.
The Company's funding policy is to contribute annually an amount that is not
less than the ERISA minimum funding requirement and not in excess of the maximum
tax-deductible contribution as developed in accordance with the aggregate cost
method. The Bank expects to contribute $222 thousand to its Pension Plan in
2004.
21
The following schedule states the change in benefit obligations for the years
ended December 31:
(in thousands) 2003 2002
- -------------------------------------------------------------------------------------------------------------------
Benefit Obligation at Beginning of Year $3,541 $3,502
Service Cost 52 33
Interest Cost 224 222
Benefits Paid (920) (695)
Increase Due to Actuarial Loss and Assumption Change 2,472 479
- -------------------------------------------------------------------------------------------------------------------
Total Benefit Obligation at End of Year $5,369 $3,541
===================================================================================================================
The Change in Plan Assets are as follows: (in thousands) 2003 2002
- -------------------------------------------------------------------------------------------------------------------
Fair Value of Plan Assets at Beginning of Year $3,104 $4,444
Employer Contribution 1,974 -
Benefits Paid (920) (695)
Actual Return on Plan Assets 33 (645)
- -------------------------------------------------------------------------------------------------------------------
Total Fair Value of Plan Assets at End of Year $4,191 $3,104
===================================================================================================================
During 2003, management changed from using an annuity payout assumption to a
lump-sum payout assumption in calculating the projected benefit obligation to
more closely mirror the anticipated benefit payment stream. This change in
estimate is reflected as an actuarial loss and increased the benefit obligation
by approximately $2.0 million in 2003.
The following table sets forth the Plan's funded status along with amounts
recognized and not recognized in the Bank's Consolidated Balance Sheets for the
years ended December 31:
(in thousands) 2003 2002
- -------------------------------------------------------------------------------------------------------------------
Benefit Obligation $ 5,369 $3,541
Fair Value of Plan Assets 4,191 3,104
- -------------------------------------------------------------------------------------------------------------------
Funded Status (1,178) (437)
Unrecognized Net Loss 3,524 1,348
Cumulative Adjustment Required to Recognize Minimum Liability (3,429) (1,262)
- -------------------------------------------------------------------------------------------------------------------
Net Amounts Recognized $(1,083) $ (351)
===================================================================================================================
Amounts Recognized: (in thousands)
- -------------------------------------------------------------------------------------------------------------------
Prepaid Benefit Cost $ - $ -
Accrued Benefit Liability (1,083) (351)
Intangible Asset - -
- -------------------------------------------------------------------------------------------------------------------
Net Amounts Recognized $(1,083) $ (351)
===================================================================================================================
The accumulated benefit obligation for the defined benefit Pension Plan was $5.3
million and $3.3 million at December 31, 2003 and 2002, respectively.
22
The components of the net periodic benefit costs are as follows:
(in thousands) 2003 2002 2001
- --------------------------------------------------------------------------------------------------------------------
Service Cost $ 52 $ 33 $ 247
Interest Cost 224 222 284
Expected Return on Plan Assets (127) (217) (414)
Amortization of
Unrecognized Prior Service Cost - (1) (3)
Unrecognized Net Loss 377 13 23
- --------------------------------------------------------------------------------------------------------------------
Total Net Periodic Benefit Cost $ 526 $ 50 $ 126
====================================================================================================================
Increase in minimum liability included in other comprehensive income $2,167 $1,262 -
====================================================================================================================
Weighted-average assumptions used to determine benefit obligations at December
31,
2003 2002
- -------------------------------------------------------------------------------
Assumptions Used in the Accounting were:
Discount Rate (Settlement Rate) 6.25%* 6.75%
Rate of Compensation Increase 4.00% 4.00%
===============================================================================
Weighted-average assumptions used to determine net benefit cost for years ended
December 31,
2003 2002 2001
- -------------------------------------------------------------------------------
Assumptions Used in the Accounting were:
Discount Rate (Settlement Rate) 6.75%* 7.25% 7.25%
Expected Return on Plan Assets 3.00% 6.00% 9.00%
Rate of Compensation Increase 4.00% 4.00% 4.00%
===============================================================================
* The Discount Rate (Settlement Rate) selected by the Bank as of December 31,
2003 was 6.25% and 6.75% as of December 31, 2002. The value of Benefit
Obligations for years after 2002 takes into account the Discount Rate and the
30-Year Treasury Securities Rate used to determine the value of a participant's
benefit under the Plan. That rate was 4.96% during 2003 and will change to 5.12%
for 2004.
The Bank utilized a 3% Expected Return on Plan assets during 2003 since it had
invested the majority of Plan assets in bank accounts or money market funds.
Beginning in November 2003, the Bank retained the services of a professional
money manager to invest the Plan assets. Both the Bank and the money manager
believe that obtaining a long-term expected return of 6% is reasonable given the
projected cash flows of the Plan.
The Bank's Pension Plan weighted-average asset allocations at December 31, 2003
and 2002, by asset category are as follows:
(in thousands) 2003 2002
- ------------------------------------------------------------------------
Savings Deposit 50% 14%
Certificates of Deposit 30% 8%
Money Market Funds 11% 9%
Bonds 4% 0%
Equity Securities 2% 0%
Mutual Funds 3% 69%
- ------------------------------------------------------------------------
Total 100% 100%
========================================================================
23
As previously discussed, in November 2003 the Bank retained the services of a
professional money manager to invest Plan assets. The trustees of the Plan
developed an investment strategy that considers projected future cash flow
requirements of Plan participants and invests the Plan assets in a mix of equity
and debt securities. Only investment grade bonds are considered for investment.
As of December 31, 2003 and 2002 the Plan assets are invested as follows:
(in thousands) 2003 2002
- ---------------------------------------------------------------------------
Corporate Bonds 13% 0%
Government Bonds 43% 0%
Equity Securities 24% 0%
Savings Deposits 0% 18%
Money Market Funds 20% 25%
Mutual Funds 0% 57%
- ---------------------------------------------------------------------------
Total 100% 100%
===========================================================================
This mix may change as projected cash flows or market conditions change.
Substantially all full-time employees of the Bank with one or more years of
service also participate in a defined contribution Profit Sharing Plan and a
Money Purchase Plan.
Contributions to the Profit Sharing Plan are made at the discretion of the Board
of Directors and the Board can terminate the Profit Sharing Plan at any time.
The Bank contributed $635,000, $625,000 and $545,000 for the years ended
December 31, 2003, 2002 and 2001, respectively. The employees are permitted,
within limitations imposed by tax law, to make pretax contributions to the
401(k) feature of the Profit Sharing Plan. The Bank does not match employee
contributions within the 401(k) feature of the Profit Sharing Plan.
The Money Purchase Plan was established January 1, 2001 to replace the defined
benefit Pension Plan that was frozen effective June 9, 2001. Substantially all
full-time employees of the Bank participate in the Money Purchase Plan, with the
exception of employees who have reached age 55 and who have accumulated 10 years
of service and are continuing to accrue benefits in the defined benefit Pension
Plan. Contributions to the Money Purchase Plan are made according to a
predetermined set of criteria. The Board can terminate the Money Purchase Plan
at any time. The Bank contributed $575,000, $522,000 and $491,000 for the years
ended December 31, 2003, 2002 and 2001, respectively.
Effective January 20, 2004 for the plan year beginning January 1, 2004, solely
for administrative purposes the Bank combined the Money Purchase and Profit
Sharing Plans into one plan, called the Profit Sharing Plan. All benefits remain
the same as under the individual plans.
The Bank sponsors a Deferred Bonus Plan for certain employees. Deferred bonuses
are granted and benefits accumulate based on the cumulative profits during the
employee's participation period. The Bank contributed $213,000, $222,000 and
$175,000 for the years ended December 31, 2003, 2002 and 2001, respectively.
Beginning in 2003, the Bank sponsored an Indexed Retirement Plan for certain
employees. The plan is designed to provide participants with supplemental
non-qualified retirement income. The Bank contributed $270,000 for the year
ended December 31, 2003.
13. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial instruments is
made in accordance with the requirements of SFAS No. 107, "Disclosure about Fair
Value of Financial Instruments." The estimated fair value amounts have been
determined by the Company using available market information and appropriate
valuation methodologies. The use of assumptions and various valuation
techniques, as well as the absence of secondary markets for certain financial
instruments, will likely reduce the comparability of fair value disclosures
between financial institutions. In some cases, book value is a reasonable
estimate of fair value due to the relatively short period of time between
origination of the instrument and its expected realization. The following table
summarized the book value and estimated fair value of financial instruments as
of December 31:
24
2003 2002
Carrying Estimated Carrying Estimated
ASSETS: (in thousands) Amount Fair Value Amount Fair Value
- --------------------------------------------- ------------- ------------- ------------ -------------
Cash and Cash Equivalents $35,800 $35,800 $ 53,574 $ 53,574
Investment Securities Held-to-Maturity 37,957 38,739 27,870 29,111
Investment Securities Available-for-Sale 223,965 223,965 206,063 206,063
Loans, Net of Unearned Income 806,906 812,067 696,675 697,351
Less: Allowance for Loan Losses 17,220 17,220 16,684 16,684
Loans, Net of Allowance 789,686 795,227 679,991 680,667
LIABILITIES:
Deposits:
Noninterest-bearing 223,000 223,000 205,997 205,997
Interest-bearing 681,349 682,880 644,228 647,291
Federal Home Loan Bank Advances 111,928 115,706 40,965 45,671
Subordinated Debentures 10,310 10,348 - -
The methods and assumptions used to estimate the fair value of each class of
financial instrument listed in the table above are explained below.
Cash and cash equivalents: The carrying amounts reported in the balance sheet
for cash and due from banks and federal funds sold are a reasonable estimate of
fair value.
Investment securities: Fair values for investment securities are based on quoted
market prices, where available. If quoted market prices are not available, fair
values are based on quoted market prices of comparable instruments.
Loans: For variable-rate loans that reprice frequently and with no significant
change in credit risk, fair values are based on carrying values. The fair values
for fixed-rate loans are estimated using discounted cash flow analyses, using
interest rates currently being offered for loans with similar terms to borrowers
of similar credit quality.
Commitments to extend credit and standby letters of credit: The fair value of
commitments is estimated using the fees currently charged to enter into similar
agreements, taking into account the remaining terms of the agreements and the
present creditworthiness of the counterparties. For fixed-rate loan commitments,
fair value also considers the difference between current levels of interest
rates and the committed rates. The fair value of letters of credit is based on
fees currently charged for similar agreements or on the estimated cost to
terminate them or otherwise settle the obligations with the counterparties at
the reporting date.
Deposit liabilities: The fair value of demand deposits, interest bearing
transaction accounts and savings accounts is the amount payable on demand as of
December 31, 2003 and 2002. The fair value of fixed-maturity certificates of
deposit is estimated by discounting expected future cash flows utilizing
interest rates currently being offered for deposits of similar remaining
maturities.
Borrowings: The fair value of federal funds purchased and other short-term
borrowings is approximated by the book value. The fair value for Federal Home
Loan Bank borrowings is determined using discounted future cash flows.
Limitations: Fair value estimates presented herein are based on pertinent
information available to management as of December 31, 2003 and 2002. Although
management is not aware of any factors that would significantly affect the
estimated fair value amounts, such amounts have not been comprehensively
revalued for purposes of these financial statements since that date, and
therefore, current estimates of fair value may differ significantly from the
amounts presented above.
25
14. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The Company uses derivative instruments to limit its exposure to declining
interest rates. The Company's current program relative to interest rate
protection primarily contemplates fixing the rates on variable rate loans. To do
this, the Company has developed a Hedging Policy to provide guidelines that
address instruments to be used, authority limits, implementation guidelines,
guidelines for evaluating hedge alternatives, reporting requirements, and the
credit worthiness of the instruments counterparty.
The Company reviews compliance with these guidelines annually with the ALCO
Committee and the Board of Directors. The guidelines may change as the Company's
business needs dictate.
In 2003 the Company terminated a no cost collar with a notional amount of $40
million on both an interest rate floor and cap. The no cost collar was accounted
for as a cash flow hedge. As a result of this termination, the Company recorded
a gain of $48 thousand in 2003. Amortization of the remaining deferred gain will
be $132 thousand in 2004.
During November 2003, the Company entered into a $20 million, two year interest
rate swap agreement maturing November 4, 2005. During December 2003, the Company
entered into a $12 million, three year interest rate swap maturing December 8,
2006. The new interest rate swap agreements effectively convert $32 million of
the Company's variable rate loans to a fixed rate in conjunction with its
ongoing rate management strategy to limit exposure to declining interest rates.
The interest rate swaps receive a fixed rate of 4.98% and 5.76% respectively,
and pay a floating rate based on Prime.
As required, the Company records in the balance sheet the interest rate swaps at
fair value. Because the transactions meet the criteria for a cash-flow hedge,
changes in fair value are reported in other comprehensive income. In the event
that a portion of the hedge becomes ineffective, the ineffective portion of the
derivative's change in fair value will be immediately recognized in earnings.
15. COMMITMENTS AND CONTINGENCIES
In the normal course of business, the Company is a party to financial
instruments with off-balance-sheet risk to meet the financing needs of its
customers and to reduce its own exposure to fluctuations in interest rates.
These instruments include commitments to extend credit, letters of credit and
financial guarantees that are not reflected in the Consolidated Balance Sheets.
The Company's exposure to credit loss in the event of nonperformance by the
other party with regard to standby letters of credit, undisbursed loan
commitments and financial guarantees is represented by the contractual notional
amount of those instruments. Commitments to extend credit are agreements to lend
to a customer as long as there is no violation of any condition established in
the contract. The Company uses the same credit policies in making commitments
and conditional obligations as it does for recorded balance sheet items. The
Company may or may not require collateral or other security to support financial
instruments with credit risk. Evaluations of each customer's creditworthiness
are performed on a case-by-case basis.
Standby letters of credit are conditional commitments issued by the Company to
guarantee performance of or payment for a customer to a third party. The Company
had standby letters of credit outstanding of $12,218,000 at December 31, 2003,
and $15,635,000 at December 31, 2002. Outstanding standby letters of credit had
original terms ranging from 4 to 110 months with final expiration in 2007.
Commitments to extend credit are agreements to lend to a customer as long as
there is no violation of any condition contained in the contract. Commitments
generally have fixed expiration dates or other termination clauses and may
require payment of a fee. Undisbursed loan commitments totaled $308,436,000 and
$269,211,000 as of December 31, 2003 and 2002, respectively. Since many of these
commitments are expected to expire without fully being drawn upon, the total
commitment amounts do not necessarily represent future cash requirements. The
Company does not anticipate any loss as a result of these transactions.
26
The Company is obligated under a number of noncancellable operating leases for
premises and equipment used for banking purposes. Minimum future rental
commitments under noncancellable operating leases as of December 31, 2003 were
$251,000, $157,000, $89,000, $47,000, and $47,000 for the years 2004 to 2008 and
$54,000 thereafter.
In the ordinary course of business, the Company becomes involved in litigation
arising out of its normal business activities. Management, after consultation
with legal counsel, is of the opinion that the ultimate liability, if any,
resulting from the disposition of such claims would not be material in relation
to the financial position of the Company.
The Company may be required to maintain average reserves on deposit with the
Federal Reserve Bank primarily based on deposits outstanding. There were no
reserve requirements during 2003 or at December 31, 2003 and 2002.
16. TRANSACTIONS WITH RELATED PARTIES
The Company, in the ordinary course of business, has had, and expects to have in
the future, deposit and loan transactions with Directors, executive officers and
their affiliated companies. These transactions were on substantially the same
terms, including interest rates, as those prevailing at the time for comparable
transactions with unaffiliated parties and do not involve more than normal
credit risk or other unfavorable features.
Loan transactions with Directors, executive officers and their affiliated
companies during the year ended December 31, 2003, were as follows:
(in thousands)
- -----------------------------------------------------------------------
Loan Balances December 31, 2002 $2,415
Disbursements During 2003 8,454
Loan Reductions During 2003 8,036
- -----------------------------------------------------------------------
Loan Balances December 31, 2003 $2,833
=======================================================================
17. RECENT ACCOUNTING DEVELOPMENTS
Derivative Instruments and Hedging Activities
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities" ("SFAS No. 149"). The provisions
of SFAS No.149 that relate to SFAS No. 133 and No. 138 implementation issues
that have been effective for fiscal quarters that began prior to June 15, 2003,
should continue to be applied in accordance with their respective effective
dates. In addition, provisions of SFAS No. 149 which relate to forward purchases
or sales of when-issued securities or other securities that do not yet exist,
should be applied to both existing contracts and new contracts entered into
after June 30, 2003. The changes in SFAS No. 149 improve financial reporting by
requiring that contracts with comparable characteristics be accounted for
similarly. In particular, SFAS No. 149 (1) clarifies under what circumstances a
contract with an initial net investment meets the characteristic of a derivative
discussed in paragraph 6(b) of SFAS No. 133 and No. 138, (2) clarifies when a
derivative contains a financing component, (3) amends the definition of an
underlying to conform it to language used in FIN 45, and (4) amends certain
other existing pronouncements. Those changes will result in more consistent
reporting of contracts as either derivatives or hybrid instruments.
SFAS No. 149 is effective for contracts entered into or modified after June 30,
2003, except as stated above and for hedging relationships designated after June
30, 2003. In addition, except as stated above, all provisions of SFAS No.149
should be applied prospectively.
The adoption of SFAS No. 149 did not have a material impact on the Company's
financial condition or operating results.
Certain Financial Instruments with Characteristics of both Liabilities and
Equity
In May 2003, the FASB issued SFAS No. 150 "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity" ("SFAS No.
150"). This statement requires that an issuer classify financial instruments
that are within its scope as a liability. Many of those instruments were
classified as equity under previous guidance.
27
Most of the guidance in SFAS No. 150 is effective for all financial instruments
entered into or modified after May 31, 2003, and otherwise effective at the
beginning of the first interim period beginning after June 15, 2003.
The adoption of SFAS No. 150 did not have a material impact on the Company's
financial condition or operating results.
Consolidation of Variable Interest Entities
In January 2003, the FASB issued FIN 46. FIN 46 explains how to identify
variable interest entities and how an enterprise assesses its interests in a
variable interest entity to decide whether to consolidate that entity. FIN 46
requires existing unconsolidated variable interest entities to be consolidated
by their primary beneficiaries if the entities do not effectively disperse risks
among parties involved. Variable interest entities that effectively disperse
risks will not be consolidated unless a single party holds an interest or
combination of interests that effectively recombines risks that were previously
dispersed.
FIN 46 applies immediately to variable interest entities created after January
31, 2003, and to variable interest entities in which an enterprise obtains an
interest after that date. It applies in the first fiscal year or interim period
ending after December 15, 2003, to variable interest entities in which an
enterprise holds a variable interest that it acquired before February 1, 2003.
FIN 46 may be applied prospectively with a cumulative-effect adjustment as of
the date on which it is first applied or by restating previously issued
financial statements for one or more years with a cumulative-effect adjustment
as of the beginning of the first year restated.
FIN 46 may have an impact on the treatment of the trust preferred securities we
have issued and ability for those instruments to continue to provide the Company
with Tier 1 capital. FIN 46 prevents the Company from consolidating the trust
entity that issued these trust preferred securities. The Federal Reserve has
issued regulations which allow for the inclusion of these instruments in Tier 1
capital regardless of the impact of FIN 46 on the consolidation of the trusts.
There remains the potential that this determination by the Federal Reserve may
be changed at a later date. We do not expect FIN 46 to have any other material
impact on the Company's financial condition or operating results.
18. PARENT COMPANY FINANCIAL INFORMATION
The financial information below is presented as of December 31, 2003 and
December 31, 2002.
Farmers & Merchants Bancorp
Balance Sheet
(in thousands) 2003 2002
- ----------------------------------------------------------------------------------------------------
Cash $ 6,905 $ 1,597
Investment in Farmers and Merchants Bank of Central California 111,272 96,601
Investment Securities 1,296 3,104
Loans 335 -
Other Assets 1,119 491
- ----------------------------------------------------------------------------------------------------
Total Assets $120,927 $101,793
====================================================================================================
Liabilities $ 10,484 -
Shareholders' Equity 110,443 101,793
- ----------------------------------------------------------------------------------------------------
Total Liabilities and Shareholders' Equity $120,927 $101,793
====================================================================================================
28
Farmers & Merchants Bancorp
Income Statement
for the period ending December 31,
2003 2002 2001
- --------------------------------------------------------------------------------------------------------------------
Equity Earnings in Farmers and Merchants Bank of Central California $ 15,203 $ 13,561 $ 12,538
Interest Income 78 167 42
Other Expenses, Net (506) (309) (263)
- --------------------------------------------------------------------------------------------------------------------
Net Income $ 14,775 $ 13,419 $ 12,317
====================================================================================================================
Farmers & Merchants Bancorp
Statement of Cash Flows
for the period ending December 31,
2003 2002 2001
- --------------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities
Net Income $14,775 $13,419 $12,317
Adjustments to Reconcile Net Income to Net Cash Used in Operating Activities:
Equity in Undistributed Net Earnings from Subsidiary (12,442) (5,460) (2,938)
Net Increase in Interest Receivable and Other Assets (448) (200) (161)
Net Increase in Interest Receivable and Other Liabilities 174 - -
- --------------------------------------------------------------------------------------------------------------------
Net Cash Provided by Operating Activities 2,059 7,759 9,218
- --------------------------------------------------------------------------------------------------------------------
Investing Activities:
Securities Purchased (393) (47) (4,291)
Securities Sold or Matured 13 1,423 254
Net Loans Originated (335) 87 27
- --------------------------------------------------------------------------------------------------------------------
Net Cash (Used) Provided by Investing Activities (715) 1,463 (4,010)
- --------------------------------------------------------------------------------------------------------------------
Financing Activities:
Subordinated Debentures Issued 10,310 - -
Stock Redemption (1,468) (5,006) (488)
Cash Dividends (4,878) (4,544) (4,056)
- --------------------------------------------------------------------------------------------------------------------
Net Cash (Used) Provided by Financing Activities 3,964 (9,550) (4,544)
- --------------------------------------------------------------------------------------------------------------------
Increase in Cash and Cash Equivalents 5,308 (328) 664
Cash and Cash Equivalents at Beginning of Year 1,597 1,925 1,261
- --------------------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents at End of Year $ 6,905 $ 1,597 $ 1,925
====================================================================================================================
29
19. LONG-TERM SUBORDINATED DEBENTURES
In December 2003, the Company formed a wholly owned Connecticut statutory
business trust, FMCB Statutory Trust I ("Statutory Trust I"), which issued
$10,000,000 of guaranteed preferred beneficial interests in the Company's junior
subordinated deferrable interest debentures (the "Trust Preferred Securities").
These debentures qualify as Tier 1 capital under Federal Reserve Board
guidelines. All of the common securities of Statutory Trust I are owned by the
Company. The proceeds from the issuance of the common securities and the Trust
Preferred Securities were used by FMCB Statutory Trust to purchase $10,310,000
of junior subordinated debentures of the Company, which carry a floating rate
based on three-month LIBOR plus 2.85%. The debentures represent the sole asset
of Statutory Trust I. The Trust Preferred Securities accrue and pay
distributions at a floating rate of three-month LIBOR plus 2.85% per annum of
the stated liquidation value of $1,000 per capital security. The Company has
entered into contractual arrangements which, taken collectively, fully and
unconditionally guarantee payment of: (i) accrued and unpaid distributions
required to be paid on the Trust Preferred Securities; (ii) the redemption price
with respect to any Trust Preferred Securities called for redemption by
Statutory Trust I, and (iii) payments due upon a voluntary or involuntary
dissolution, winding up or liquidation of Statutory Trust I. The Trust Preferred
Securities are mandatorily redeemable upon maturity of the debentures on
December 17, 2033, or upon earlier redemption as provided in the indenture. The
Company has the right to redeem the debentures purchased by Statutory Trust I,
in whole or in part, on or after December 17, 2008. As specified in the
indenture, if the debentures are redeemed prior to maturity, the redemption
price will be the principal amount and any accrued but unpaid interest.
30
Five Year Financial Summary of Operations
(in thousands, except per share data)
2003 2002 2001 2000 1999
- --------------------------------------------------------------------------------------------------------------------
Total Interest Income $ 54,884 $54,238 $63,530 $66,127 $56,055
Total Interest Expense 11,073 13,596 23,280 24,757 18,862
------------------------------------------------------------------------------------------------------------------
Net Interest Income 43,811 40,642 40,250 41,370 37,193
Provision for Loan Losses 625 4,926 1,000 2,800 1,700
------------------------------------------------------------------------------------------------------------------
Net Interest Income After
Provision for Loan Losses 43,186 35,716 39,250 38,570 35,493
Total Non-Interest Income 12,918 13,866 8,374 6,648 5,658
Total Non-Interest Expense 33,286 29,109 27,486 27,548 27,021
------------------------------------------------------------------------------------------------------------------
Income Before Income Taxes 22,818 20,473 20,138 17,670 14,130
Provision for Income Taxes 8,043 7,054 7,821 6,650 4,914
------------------------------------------------------------------------------------------------------------------
Net Income $ 14,775 $13,419 $12,317 $11,020 $ 9,216
==================================================================================================================
Balance Sheet Data
Total Assets $1,148,565 $1,021,907 $970,883 $905,551 $819,881
Loans 806,906 696,675 602,169 497,397 413,409
Allowance for Loan Losses 17,220 16,684 12,709 11,876 9,787
Investment Securities 261,922 233,933 275,550 320,654 346,855
Deposits 904,349 850,225 819,711 764,678 685,143
Federal Home Loan Bank Advances 111,928 40,965 41,000 41,033 41,064
Shareholders' Equity 109,605 103,565 100,736 90,883 80,201
Selected Ratios
Return on Average Assets 1.36% 1.41% 1.35% 1.29% 1.19%
Return on Average Equity - Net of Accumulated 13.88% 13.51% 13.14% 12.38% 10.95%
Other Comprehensive Income
Dividend Payout Ratio 33.02% 33.86% 32.93% 33.66% 36.30%
Average Loan to Average Deposits 85.29% 79.71% 68.37% 59.96% 52.93%
Average Equity - Net of Accumulated Other 9.83% 10.43% 10.25% 10.40% 10.86%
Comprehensive Income - to Average Assets
Period-end Shareholders' Equity to Total Assets 9.54% 10.13% 10.38% 10.04% 9.78%
Per Share Data
Net Income (1) $19.30 $17.34 $15.57 $13.88 $11.53
Cash Dividends Declared $6.20 $ 6.00 $5.45 $ 5.00 $4.50
(1) Net Income per share is based on the weighted average number of shares
outstanding of 765,433, 774,066, 791,125, 793,959 and 799,081 for the years
ended December 31, 2003, 2002, 2001, 2000 and 1999, respectively. Prior years'
per share data has been restated for the 5% stock dividend issued in each of the
above years.
31
Quarterly Financial Data
(in thousands, except for per share data)
First Second Third Fourth
2003 Quarter Quarter Quarter Quarter Total
-----------------------------------------------------------------------------------------------------------------
Total Interest Income $13,199 $13,870 $13,775 $14,040 $54,884
Total Interest Expense 2,878 2,947 2,710 2,538 11,073
-----------------------------------------------------------------------------------------------------------------
Net Interest Income 10,321 10,923 11,065 11,502 43,811
Provision for Loan Losses 200 125 150 150 625
-----------------------------------------------------------------------------------------------------------------
Net Interest Income After
Provision for Loan Losses 10,121 10,798 10,915 11,352 43,186
Total Non-Interest Income 2,951 3,187 3,210 3,570 12,918
Total Non-Interest Expense 7,749 8,320 8,072 9,145 33,286
-----------------------------------------------------------------------------------------------------------------
Income Before Income Taxes 5,323 5,665 6,053 5,777 22,818
Provision for Income Taxes 1,922 2,021 2,173 1,927 8,043
-----------------------------------------------------------------------------------------------------------------
Net Income $ 3,401 $ 3,644 $ 3,880 $ 3,850 $14,775
=================================================================================================================
Earnings Per Share (1) $ 4.43 $ 4.76 $ 5.08 $ 5.04 $ 19.30
=================================================================================================================
2002
-----------------------------------------------------------------------------------------------------------------
Total Interest Income $13,685 $13,554 $13,564 $13,435 $54,238
Total Interest Expense 3,884 3,423 3,218 3,071 13,596
-----------------------------------------------------------------------------------------------------------------
Net Interest Income 9,801 10,131 10,346 10,364 40,642
Provision for Loan Losses 200 300 500 3,926 4,926
-----------------------------------------------------------------------------------------------------------------
Net Interest Income After
Provision for Loan Losses 9,601 9,831 9,846 6,438 35,716
Total Non-Interest Income 2,204 2,951 2,731 5,980 13,866
Total Non-Interest Expense 6,946 7,559 7,152 7,452 29,109
-----------------------------------------------------------------------------------------------------------------
Income Before Income Taxes 4,859 5,223 5,425 4,966 20,473
Provision for Income Taxes 1,797 1,903 1,980 1,374 7,054
-----------------------------------------------------------------------------------------------------------------
Net Income $ 3,062 $ 3,320 $ 3,445 $ 3,592 $13,419
=================================================================================================================
Earnings Per Share (1) $ 3.91 $ 4.30 $ 4.47 $ 4.66 $ 17.34
=================================================================================================================
Farmers & Merchants Bancorp stock is not traded on any exchange. The shares are
primarily held by local residents and are not actively traded. Dividends
declared semiannually during the past three years were for the following
amounts: June 2003, 2002 and 2001, $2.10, $2.00 and $1.95 per share,
respectively, and for December 2003, 2002, and 2001, $4.10, $4.00 and $3.50 per
share, respectively. Based on information from shareholders and from Company
stock transfer records, the prices paid in 2003, 2002 and 2001 ranged from
$225.00 to $375.00 per share.
(1) Prior years' per share data has been restated for the 5% stock dividend
issued in each of the above years.
32
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
Forward-Looking Statements
This annual report contains various forward-looking statements, usually
containing the words "estimate," "project," "expect," "objective," "goal," or
similar expressions and includes assumptions concerning the Company's
operations, future results, and prospects. These forward-looking statements are
based upon current expectations and are subject to risk and uncertainties. In
connection with the "safe-harbor" provisions of the private Securities
Litigation Reform Act, the Company provides the following cautionary statement
identifying important factors which could cause the actual results of events to
differ materially from those set forth in or implied by the forward-looking
statements and related assumptions.
Such factors include the following: (i) the effect of changing regional and
national economic conditions; (ii) significant changes in interest rates and
prepayment speeds; (iii) credit risks of commercial, real estate, consumer, and
other lending activities; (iv) changes in federal and state banking laws or
regulations; (v) competitive pressure in the banking industry; (vi) changes in
governmental fiscal or monetary policies; (vii) uncertainty regarding the
economic outlook resulting from the continuing war on terrorism, as well as
actions taken or to be taken by the U.S. or other governments as a result of
further acts or threats of terrorism; (viii) dividend restrictions; (ix)
asset/liability pricing risks and liquidity risks; (x) changes in the securities
markets; (xi) certain operational risks involving data processing systems or
fraud; (xii) the State of California's fiscal difficulties; and (xiii) other
external developments which could materially impact the Company's operational
and financial performance.
Readers are cautioned not to place undue reliance on these forward-looking
statements which speak only as of the date hereof. The Company undertakes no
obligation to update any forward-looking statements to reflect events or
circumstances arising after the date on which they are made.
Introduction
Farmers & Merchants Bancorp is a bank holding company formed March 10, 1999. Its
subsidiary, Farmers & Merchants Bank of Central California is a California
state-chartered bank formed in 1916. The Bank services the northern Central
Valley of California with 18 banking offices. The service area includes
Sacramento, San Joaquin, Stanislaus and Merced Counties with branches in
Sacramento, Elk Grove, Galt, Lodi, Stockton, Linden, Modesto, Turlock and
Hilmar.
Substantially all of the Company's business activities are conducted within its
market area.
This section should be read in conjunction with the consolidated financial
statements and the notes thereto, along with other financial information
included in this report.
33
Overview
The Five Year Period: 1999 through 2003
The following table presents key performance data for the Company over the past
five years.
(in thousands, except per share data)
Financial Performance Indicator 2003 2002 2001 2000 1999
Net Income $ 14,775 $ 13,419 $ 12,317 $ 11,020 $ 9,216
Total Assets $ 1,148,565 $ 1,021,907 $970,883 $905,551 $819,881
Total Loans $ 806,906 $ 696,675 $602,169 $497,397 $413,409
Total Deposits $ 904,349 $ 850,225 $819,711 $764,678 $685,143
Total Shareholders' Equity $ 109,605 $ 103,565 $100,736 $ 90,883 $ 80,201
Total Risk-Based Capital Ratio 13.24% 12.25% 13.76% 15.41% 16.92%
Non-Performing Loans as a % of Total Loans 0.32% 0.42% 0.40% 0.30% 0.61%
Net Charge-Offs to Average Loans 0.01% 0.15% 0.03% 0.16% 0.14%
Loan Loss Allowance as a % of Total Loans 2.13% 2.39% 2.11% 2.39% 2.37%
Return on Average Equity (1) 13.88% 13.51% 13.14% 12.38% 10.95%
Earnings Per Share (2) $ 19.30 $ 17.34 $ 15.57 $ 13.88 $ 11.53
Cash Dividends Per Share (2) $ 6.20 $ 6.00 $ 5.45 $ 5.00 $ 4.50
Cash Dividends Declared (3) $ 4,736 $ 4,404 $ 3,923 $ 3,609 $ 3,273
# Shares Repurchased During Year 5,732 20,749 2,053 5,994 2,306
Average Share Price of Repurchased Shares $ 256 $ 241 $ 238 $ 210 $ 175
High Stock Price - Fourth Quarter $ 375.00 $ 300.00 $ 250.00 $ 245.00 $ 210.00
Low Stock Price - Fourth Quarter $ 300.00 $ 250.00 $ 250.00 $ 240.00 $ 210.00
- -------------------------------------------------------
(1) Equity is calculated net of accumulated other comprehensive income.
(2) Prior years' per share data has been restated for the 5% stock dividend
issued in each of the above years.
(3) Not including cash paid in lieu of fractional shares related to the stock
dividend. These payments totaled $587,000 over the five year period.
During the five year period 1999 through 2003, the Company's operating
performance improved every year.
o Annual net income increased 61% to $14.8 million from $9.2 million.
o Earnings Per Share increased 67% to $19.30 from $11.53.
o Total assets increased 40% to $1.1 billion.
o Total loans increased 95% to $806.9 million.
Importantly, during this period of asset and earnings growth.
o The Company's risk based capital ratio has remained above the 10% level
that federal and state banking regulators require for banks to be
considered "well capitalized" (see Financial Condition - Capital).
o The Bank's asset quality has remained strong, as reflected by net
charge-offs never exceeding 0.16% of average loans in any year and
non-performing loans totaling 0.32% of total loans at December, 31, 2003
(see Financial Condition - Non-Performing Assets).
o The Bank's allowance for loan losses has been maintained at above 2% of
total loans, providing a strong reserve for future loan losses (see Results
of Operations - Provision and Allowance for Loan Losses).
As a result of this strong earnings performance, capital position and asset
quality, shareholders have benefited well in excess of overall stock market
returns over the past five years.
34
o Return on Average Equity has increased every year from 10.95% in 1999 to
13.88% in 2003.
o Cash Dividends per Share have increased 38% since 1999, and totaled $27.15
per share over the five year period.
o The market price of the Company's stock has increased $225 per share from a
high of $150 in the fourth quarter of 1998 to a high of $375 in the fourth
quarter of 2003. This increase in shareholder value has been further
enhanced by the 5% stock dividend declared in each year, resulting in the
average shareholder owning approximately 126 shares at December 31, 2003
for every 100 shares they owned at December 31, 1998.
o The combination of cash dividends, stock dividends, cash payments in lieu
of fractional shares from stock dividends and increase in market value of
the stock has provided investors with a total return exceeding 230% during
the five year period. In our opinion, this compares very favorably to
overall stock market returns as represented by the AMEX Market Index and
the Media General Index of Banks and Bank Holding Companies (see
Performance Graph in the Company's definitive proxy statement for the 2004
Annual Meeting of Shareholders).
o The total market capitalization of the Company has increased by $192
million over the five year period.
As part of an overall capital management program, in 1998 the Board approved a
stock repurchase program. Since 1999, the Company has repurchased over 36,000
shares for total consideration of $8.6 million. The Company will continue to
repurchase shares when it believes it is in the best long-term interest of
shareholder value.
The Current Year: 2003
At the completion of our 87th year, management and the Board are pleased to
report the highest net income in the Company's history. As of December 31, 2003,
Farmers & Merchants Bancorp reported net income of $14.8 million, earnings per
share of $19.30, return on average assets of 1.36% and return on average equity
of 13.88% (net of accumulated other comprehensive income).
The Company's continuing strong earnings performance in 2003 was due to a
combination of (1) growth in earning assets, (2) improvement in the mix of
earning assets as reflected by an increase in loans as a percentage of average
earning assets, (3) reduction in the provision for loan losses, and (4)
continued strong expense control as reflected in an efficiency ratio of 58%.
These factors combined to offset a decline in the Bank's net interest margin as
a result of continued declines in interest rates during the first half of 2003.
The following is a summary of the financial accomplishments achieved during
2003.
o Net income increased 10.1% to $14.8 million from $13.4 million.
o Earnings per share increased 11.3% to $19.30 from $17.34.
o Net interest income increased 7.8% to $43.8 million from $40.6 million.
o Total assets increased 12.4% to $1.15 billion from $1.02 billion.
o Investment securities increased 11.9% to $261.9 million from $233.9
million.
o Gross loans increased 15.8% to $806.9 million from $696.7 million.
35
o Total deposits increased 6.4% to $904.3 million from $850.2 million.
o Total shareholders' equity increased 5.8% to $109.6 million, after
dividends of $4.7 million, stock buybacks of $1.5 million and a decline in
Accumulated Other Comprehensive Income of $1.3 million.
o Total market capitalization increased $67 million.
RESULTS OF OPERATIONS
The following discussion and analysis is intended to provide a better
understanding of Farmers & Merchants Bancorp and its subsidiaries' performance
during 2003 and 2002, the material changes in financial condition, operating
income and expense of the Company and its subsidiaries as shown in the
accompanying financial statements.
Net Interest Income
Net interest income is the amount by which the interest and fees on loans and
other interest earning assets exceed the interest paid on interest bearing
sources of funds. For the purpose of analysis, the interest earned on tax-exempt
investments and municipal loans is adjusted to an amount comparable to interest
subject to normal income taxes. This adjustment is referred to as "taxable
equivalent" adjustment and is noted wherever applicable. Interest income and
expense are affected by changes in the volume and mix of average interest
earning assets and average interest bearing liabilities, as well as fluctuations
in interest rates. Therefore, increases or decreases in net interest income are
analyzed as changes in volume, changes in rate and changes in the mix of assets
and liabilities.
The Company's earning assets and rate sensitive liabilities are subject to
repricing at different times, which exposes the Company to income fluctuations
when interest rates change. In order to minimize income fluctuations, the
Company attempts to match asset and liability maturities. However, some maturity
mismatch is inherent in the asset and liability mix. See Market Risk-Interest
Rate Risk.
Net interest income increased 7.8% to $43.8 million during 2003. During 2002,
net interest income was $40.6 million, representing an increase of 1.0% from
2001. On a taxable equivalent basis, net interest income increased 8.1% and
totaled $45.4 million during 2003, compared to $42.0 million for 2002. In 2001,
on a taxable equivalent basis, net interest income decreased 2.9% or $1.2
million from that of 2000. The primary reason for the increase in net interest
income during 2003 was an improvement in the volume and mix (as reflected by an
increase in loans as a percentage of average earning assets) of earning assets.
These factors combined to offset the negative impact on the Bank's net interest
income as a result of a continuing decline in market interest rates during the
first half of the year. During 2003, the Federal Reserve Bank dropped their
Discount Rate by 25 basis points, following a drop of 50 basis points during
2002. This resulted in an equivalent drop in the Bank's prime rate, the index on
which many of its loans are priced.
Net interest income on a taxable equivalent basis, expressed as a percentage of
average total earning assets, is referred to as the net interest margin. For
2003, the Company's net interest margin was 4.50% compared to 4.76% in 2002. The
decrease in the net interest margin during 2003 was due primarily to a
continuing decline in market interest rates through the first half of 2003. The
Bank's earning assets, particularly loans, generally reprice more quickly than
its interest bearing liabilities, causing a decrease in net interest margin as
market interest rates decline. This continuing decline in market interest rates
offset the positive impact on the 2003 net interest margin that occurred as a
result of the previously discussed improvement in the mix of earning assets. As
market interest rates stabilize or begin to rise, the net interest margin is
expected to improve.
Loans, generally the Company's highest earning assets, increased $110.2 million
as of December 31, 2003 compared to December 31, 2002. On an average balance
basis, loans increased by $100.1 million for the year ended December 31, 2003.
As a result of this loan growth, the mix of the Company's earning assets
improved as loans increased from 72.4% of average earning assets during 2002 to
73.1% in 2003. Due to the decline in market interest rates during 2002 and the
first half of 2003, the year-to-date yield on the loan portfolio decreased 49
basis points to 6.08% for the year ended December 31, 2003 compared to 6.57% for
the year ended December 31, 2002. This decrease in yield was offset by the
growth in loan balances, which resulted in interest revenue from loans
increasing 7.1% to $44.9 million for 2003.
36
The investment portfolio is the other main component of the Company's earning
assets. The Company invests primarily in mortgage-backed securities, U.S.
Government Agencies, and high-grade municipals. Since the risk factor for these
types of investments is significantly lower than that of loans, the yield earned
on investments is generally less than that of loans.
Average investment securities increased $45.0 million in 2003 compared to the
average balance during 2002. Even with the increase in the average balance of
investment securities there was a decrease in interest income of $1.7 million
for the year ended December 31, 2003, due to the declining market interest rate
environment and the fact that rates have remained low for a substantial time
resulting in maturities in the portfolio being reinvested at rates significantly
below prior years. The average yield, on a taxable equivalent basis, in the
investment portfolio was 4.5% in 2003 compared to 6.2% in 2002. Net interest
income on the Schedule of Year-to-Date Average Balances and Interest Rates in
the Company's Form 10-K is shown on a taxable equivalent basis, which is higher
than net interest income as reflected on the Consolidated Statements of Income
because of adjustments that relate to income on securities that are exempt from
federal income taxes.
Average interest-bearing sources of funds increased $106.5 million or 16.1%
during 2003. Of that increase, average borrowed funds (primarily FHLB Advances)
increased $59.5 million and interest-bearing deposits increased $46.6 million.
During 2003, the Bank was able to grow average interest bearing deposits by
$46.6 million. The increase was primarily in savings deposits, which grew $44.1
million, as higher cost time deposits were reduced by $10.2 million. Total
interest expense on deposit accounts for 2003 was $8.1 million as compared to
$11.4 million in 2002. Even as deposits increased, due to a continuing decline
in market interest rates throughout the first half of 2003, interest expense on
deposits decreased 28.6% or $3.3 million in 2003. The average rate paid on
interest-bearing deposits was 1.2% in 2003 and 1.8% in 2002. The percentage
decline in interest expense did not match the decline in loan yields due to the
fact that deposit products generally do not reprice as quickly as loan products.
During March and April, 2003, the Bank implemented an asset/liability strategy
designed to both increase its net interest income and reduce the overall
maturity mismatch in its asset and liability mix. This strategy involved
borrowing $80 million of short-term advances from the Federal Home Loan Bank
(FHLB) and investing primarily in mortgage-backed securities and high-grade
municipals. As a result of this strategy, FHLB advances increased from $41.0
million as of December 31, 2002 to $111.9 million as of December 31, 2003. Total
interest expense on FHLB advances for 2003 was $2.9 million. In 2002, interest
expense on FHLB Advances was $2.2 million. The average rate paid on FHLB
Advances was 3.0% in 2003 down from 5.4% in 2002.
Provision and Allowance for Loan Losses
As a financial institution that assumes lending and credit risks as a principal
element of its business, credit losses will be experienced in the normal course
of business. The allowance for loan losses is established to absorb losses
inherent in the loan portfolio. The allowance for loan losses is maintained at a
level considered by management to be adequate to provide for risks inherent in
the loan portfolio. The allowance is increased by provisions charged to
operating expense and reduced by net charge-offs. In determining the adequacy of
the allowance for loan losses, management takes into consideration examinations
by the Company's supervisory authorities, results of internal credit reviews,
financial condition of borrowers, loan concentrations, prior loan loss
experience, and general economic conditions. The allowance is based on estimates
and ultimate losses may vary from the current estimates. Management reviews
these estimates periodically and, when adjustments are necessary, they are
reported in the period in which they become known.
After reviewing all factors, management concluded that the allowance for loan
losses as of December 31, 2003 was adequate.
37
The provision for loan losses totaled $625,000 in 2003, compared to $4.9 million
in 2002. The decrease in the provision was the result of management's evaluation
of the adequacy of the allowance for loan losses relative to factors such as the
credit quality of the loan portfolio, loan growth, current loan losses, the
prevailing economic climate, and its effect on borrowers' ability to repay loans
in accordance with the terms of the notes.
As of December 31, 2003, the allowance for loan losses was $17.2 million, which
represented 2.1% of the total loan balance. At December 31, 2002 the allowance
for loan losses was $16.7 million or 2.4% of the total loan balance.
The table below illustrates the change in the allowance for loan losses for the
years 2003 and 2002.
Allowance for Loan Losses
(dollar amounts in thousands)
Balance, December 31, 2002 $ 16,684
Provision Charged to Expense 625
Recoveries of Loans Previously Charged Off 608
Loans Charged Off (697)
=======================================================================
Balance, December 31, 2003 $ 17,220
=======================================================================
Balance, December 31, 2001 $ 12,709
Provision Charged to Expense 4,926
Recoveries of Loans Previously Charged Off 335
Loans Charged Off (1,286)
=======================================================================
Balance, December 31, 2002 $ 16,684
=======================================================================
Non-Interest Income
Non-interest income for the Company includes income derived from services
offered by the Bank, such as merchant bankcard, investment services and other
miscellaneous business services; it also includes service charges and fees from
deposit accounts, net gains and losses from the sale of investment securities,
increases in the cash surrender value of bank owned life insurance and gains and
losses from the sale of assets and other real estate owned.
Non-interest income totaled $12.9 million for 2003. This represents a decrease
of $948,000 or 6.8%, from non-interest income of $13.8 million for 2002. During
2002, non-interest income increased $5.5 million or 65.6% over non-interest
income of $8.4 million for 2001. The decrease in non-interest income between
2002 and 2003 was primarily due to the fact that during 2002 the Bank recorded a
gain of $2.8 million from the sale of preferred stock previously acquired
through a troubled debt restructuring. After adjusting for this non-recurring
transaction, non-interest income increased $1.8 million or 16.7% in 2003 over
2002.
Service charges on deposit accounts totaled $4.9 million in 2003. This
represents an increase of $132,000 or 2.8% over service charges on deposit
accounts of $4.8 million in 2002. Service charges on demand deposit accounts for
business customers are generally charged based on an analysis of their activity.
The activity charges for a given month may be offset by an earnings credit. The
lower interest rate environment resulted in a lower account earnings credit thus
generally increasing service charges on business deposit accounts. Service
charges in 2002 increased $581,000 or 13.9% over service charges on deposit
accounts of $4.2 million in 2001.
Gain on Sale of Investment Securities totaled $935,000 in 2003. This represents
an increase of $659,000 or 238.8% over 2002. During 2003 the Bank took advantage
of historically low interest rates to restructure its investment portfolio by
selling certain securities at a gain.
38
The Bank provides merchant bankcard services to business customers in its
service area. Fee income of $1.7 million was generated in 2003. This represents
an increase of $243,000 or 17.2% over fee income of $1.4 million in 2002. Fee
income of $1.2 million was generated in 2001. The increase during 2003 was due
to an increase in merchant volume during the year.
During 2002 the Bank purchased life insurance on its key executives. The
increase in the cash surrender value of such policies for 2003 was $1.5 million,
an increase of $107,000 or 7.5% over 2002.
Other non-interest income totaled $3.9 million in 2003, an increase of $711,000
or 22.3% over 2002. In 2002, other non-interest income totaled $3.2 million
compared to $2.9 million in 2001. Fees from these services include ATM fees,
wire transfer fees, gain on sale of mortgage loans and other miscellaneous
charges
Non-Interest Expense
Non-interest expense for the Company includes expenses for salaries and employee
benefits, occupancy, equipment, supplies, legal fees, professional services,
data processing, marketing, deposit insurance, merchant bankcard operations, and
other miscellaneous expenses.
Overall, non-interest expense increased $4.2 million or 14.3% for the year ended
December 31, 2003, primarily as a result of a $3.3 million increase in Salaries
and Employee Benefits. This increase was due to: (1) 18 month cycle salary merit
increases which occurred in October, 2002, (2) increased contributions to the
Bank's Supplemental Retirement Plan and (3) increased expense recognition
associated with the Bank's Defined Benefit Pension Plan (see Note 12 of Notes to
Consolidated Financial Statements). At the end of 2003, the Company had 291 full
time equivalent employees compared to 292 at the end of 2002 and 304 at the end
of 2001.
Occupancy and equipment expenses represent the cost of operating and maintaining
branch and administrative facilities, including the purchase and maintenance of
furniture, fixtures, and office equipment and data processing equipment.
Occupancy expense in 2003 totaled $1.6 million, a decrease of $118,000 or 6.9%
over 2002. During 2002, occupancy expense increased $29,000 or 1.7% over 2001.
Equipment expense in 2003 totaled $2.4 million, an increase of $269,000 or 12.5%
over 2002. During 2002, equipment expense increased 5.9% or $120,000 over 2001.
Other operating expense totaled $8.2 million, a 10.2% increase from the prior
year. This increase in other operating expense during 2003 was due primarily to
an increase in professional services associated with ongoing projects to either
improve operating efficiency or enhance risk management. During 2002, other
operating expense was $7.5 million compared to $6.8 million in 2001.
Income Taxes
The provision for income taxes increased $989,000 during 2003. The provision for
income taxes decreased $767,000 in 2002 as a result of the purchase of bank
owned life insurance on which the increase in cash surrender value is tax
exempt. The effective tax rate in 2003 was 35.2% compared to 34.5% in 2002 and
38.8% in 2001. The effective rates were lower than the statutory rate of 42% due
primarily to benefits regarding the cash surrender value of life insurance; the
California bad debt deduction; California enterprise zone interest income
exclusion; and tax exempt interest income on municipal securities and loans.
Current tax law causes the Company's current taxes payable to approximate or
exceed the current provision for taxes on the income statement. Two provisions
have had a significant effect on the Company's current income tax liability; the
restrictions on the deductibility of loan losses and the mandatory use of
accrual accounting for taxes rather than the cash basis method of accounting.
FINANCIAL CONDITION
Investment Securities
The Financial Accounting Standards Board statement, Accounting for Certain
Investments in Debt and Equity Securities, requires the Company to classify its
investments as held-to-maturity, trading or available-for-sale. Securities are
classified as held-to-maturity and are carried at amortized cost when the
Company has the positive intent and ability to hold the securities to maturity.
39
Trading securities are securities acquired for short-term appreciation and are
carried at fair value, with unrealized gains and losses recorded in non-interest
income. As of December 31, there were no securities in the trading portfolio.
Securities classified as available-for-sale include securities, which may be
sold to effectively manage interest rate risk exposure, prepayment risk, satisfy
liquidity demands and other factors. These securities are reported at fair value
with aggregate, unrealized gains or losses excluded from income and included as
a separate component of shareholders' equity, net of related income taxes.
The investment portfolio provides the Company with an income alternative to
loans. The Company's total investment portfolio represented 22.8% of the
Company's total assets during 2003 and 22.9% of the Company's total assets
during 2002. Not included in the investment portfolio are overnight investments
in Federal Funds Sold. In 2003, average Federal Funds Sold on a year to date
basis was $15.9 million compared to $33.0 million in 2002.
The Company's investment portfolio at the end of 2003 was $261.9 million, an
increase of $28.0 million from 2002. As previously discussed (see "Net Interest
Income"), the Bank implemented an asset/liability strategy involving FHLB
borrowings invested in investment securities. This strategy offset the runoff in
the Bank's investment portfolio that was used to fund the Company's loan growth
during 2003. On an average balance basis, the Company's investments in
non-taxable "qualified issues" of states and political subdivisions were $70.0
million in 2003 and $51.0 million for 2002. Qualified issues are municipal
obligations that are considered "small issues" and meet Internal Revenue Service
requirements. By meeting these requirements, the interest earned from qualified
issues is exempt from federal income taxes.
Note 3 in the Notes to Consolidated Financial Statements displays the
classifications of the Company's investment portfolio, the market value of the
Company's investment portfolio and the maturity distribution.
Loans
The Company has established credit management policies and procedures that
govern both the approval of new loans and the monitoring of the existing
portfolio. The Company manages and controls credit risk through comprehensive
underwriting and approved standards, portfolio diversification guidelines,
dollar limits on loans to one borrower and by restricting loans made primarily
to its principal market area where management believes it is better able to
assess the applicable risk. Management reports regularly to the Board of
Directors regarding trends and conditions in the loan portfolio and regularly
conducts credit reviews of individual loans. Loans that are performing but have
shown some signs of weakness are subjected to more stringent reporting and
oversight.
The Company's loan portfolio at December 31, 2003 increased $110.2 million from
December 31, 2002. The increase was due to strong loan demand in the Company's
market area, along with an aggressive calling program on high quality loan
prospects. Additionally, on an average balance basis, loans have increased
$100.1 million or 15.7%. In 2002, average balances increased from the prior year
by 21.5% or $112.7 million. The table following sets forth the distribution of
the loan portfolio by type as of the dates indicated.
40
Loan Portfolio As Of:
(in thousands) December 31, 2003 December 31, 2002
- ---------------------------- ------------------------- ----------------------
Real Estate $386,735 $322,074
Real Estate Construction 77,115 66,467
Home Equity 55,827 45,150
Agricultural 134,862 109,130
Commercial 136,955 135,877
Consumer 17,504 19,995
- ---------------------------- ------------------------- ----------------------
Gross Loans 808,998 698,693
Less:
Unearned Income 2,092 2,018
Allowance for Loan Losses 17,220 16,684
- ---------------------------- ------------------------- ----------------------
Net Loans $789,686 $ 679,991
============================ ========================= ======================
In the ordinary course of business, the Company enters into commitments to
extend credit to its customers. These commitments are not reflected in the
accompanying consolidated financial statements. As of December 31, 2003, the
Company had entered into loan commitments amounting to $308.4 million compared
to $269.2 million at December 31, 2002. Letters of credit issued by the Company
at December 31, 2003, and December 31, 2002, were $12.2 million and $15.6
million, respectively.
Non-Performing Assets
Non-performing assets are comprised of non-performing loans (defined as
non-accrual loans plus accruing loans past due 90 days or more) and other real
estate owned. As set forth in the table below, non-performing loans as of
December 31, 2003 were $2.6 million compared to $2.9 million at December 31,
2002. The Company reported no other real estate owned for both December 31, 2003
and December 31, 2002.
The Company's policy is to place loans on non-accrual status when, for any
reason, principal or interest is past due for ninety days or more unless it is
both well secured and in the process of collection. Any interest accrued, but
unpaid, is reversed against current income. Thereafter, interest is recognized
as income only as it is collected in cash. Accrued interest reversed from income
on loans placed on a non-accrual status totaled $356,000 at December 31, 2003
compared to $331,000 at December 31, 2002. Non-accrual loans to total loans for
the year ended 2003 was 0.3%. For the year ended 2002 the percentage was 0.4%.
Non-Performing Assets
(dollar amounts in thousands) December 31, 2003 December 31, 2002
- --------------------------------------- ------------------ --------------------
Non-performing Loans $2,584 $2,907
Other Real Estate Owned - -
======================================= ================== ====================
Total $2,584 $2,907
======================================= ================= =====================
Non-Performing Assets
as a % of Total Loans 0.32% 0.42%
Allowance for Loan Losses as a % of
Non-Performing Loans 666.4% 573.9%
41
Except for non-performing loans shown in the table above, the Bank's management
is not aware of any loans as of December 31, 2003 for which known credit
problems of the borrower would cause serious doubts as to the ability of such
borrowers to comply with their present loan repayment terms, or any known events
that would result in the loan being designated as non-performing at some future
date. The Bank's management cannot, however, predict the extent to which any
deterioration in general economic conditions, real estate values, increase in
general rates of interest, change in the financial conditions or business of a
borrower may adversely affect a borrower's ability to pay.
Although management believes that non-performing loans are generally well
secured and that potential losses are provided for in the Company's allowance
for loan losses, there can be no assurance that future deterioration in economic
conditions or collateral values will not result in future credit losses.
Deposits
One of the key sources of funds to support earning assets is the generation of
deposits from the Company's customer base. The ability to expand the customer
base and subsequently deposits is a significant element in the performance of
the Company.
At December 31, 2003, deposits totaled $904.3 million. This represents an
increase of 6.4% or $54.1 million from December 31, 2002. The increase was
focused in savings and demand deposit accounts, which increased $44.1 million
and $17.0 million, respectively. Time deposit accounts decreased $10.1 million
or 3.2% from December 31, 2002 as customers transferred balances to more liquid
savings and demand deposit accounts in anticipation of rising rates at some time
in the future. The Bank's calling efforts for prospective customers includes
acquiring both loan and deposit relationships which results in new demand,
interest bearing transaction and savings accounts. In addition, the opening of a
new branch in Stockton in September 2002 and Modesto in September 2003 provided
additional deposit growth.
The change in the mix of deposits occurs as interest rates change. The
expectations our customers have of future interest rates, dictates their
maturity and account selections. As rates decreased during 2002 and the first
half of 2003, some customers moved from time deposits to demand and savings
accounts because they anticipated rates would rise and were unwilling to commit
their deposits to long term investments at the current rates.
The most volatile deposits in any financial institution are certificates of
deposit over $100,000. The Company has not found its certificates of deposit
over $100,000 to be as volatile as some other financial institutions as it does
not solicit these types of deposits from brokers nor does it offer interest rate
premiums. It has been the Company's experience that large depositors have placed
their funds with the Company due to its strong reputation for safety, security
and liquidity. Management believes that this is supported by the fact that the
$10.1 million decrease in time deposit accounts during 2003 referenced above
occurred only in certificates of deposit under $100,000. Certificates of deposit
over $100,000 increased $5.7 million or 4.8% during 2003.
Federal Home Loan Bank Advances
Advances from the Federal Home Loan Bank (FHLB) are another key source of funds
to support earning assets. These advances are also used to manage the Bank's
interest rate risk exposure, and as opportunities exist to borrow and invest the
proceeds at a positive spread through the investment portfolio. FHLB advances as
of December 31, 2003 were $111.9 million compared to $41.0 million as of
December 31, 2002. As previously discussed (see Net Interest Income), the Bank
implemented an asset/liability strategy involving FHLB borrowings invested in
investment securities. The average rate paid for FHLB advances was 3.0% in 2003
compared to 5.4% in 2002.
Long-term Subordinated Debentures
On December 17, 2003 the Company raised $10 million through an offering of trust
preferred securities. See Note 19 of Notes to Consolidated Financial Statements.
Although this amount is reflected as subordinated debt on the Company's balance
sheet, under applicable regulatory guidelines, trust preferred securities
qualify as regulatory capital (see Capital). These securities accrue interest at
a variable rate based upon 3-month Libor plus 2.85%. Interest rates reset
quarterly (beginning March 17, 2004) and were 4.02% as of December 31, 2003.
Since these securities were outstanding for only 15 days during 2003, their
impact on interest expense was immaterial.
42
Capital
The Company relies primarily on capital generated through the retention of
earnings to satisfy its capital requirements. The Company engages in an ongoing
assessment of its capital needs in order to support business growth and to
insure depositor protection. Shareholders' Equity totaled $109.6 million at
December 31, 2003 and $103.6 million at the end of 2002.
The Company and the Bank are subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum capital
requirements can initiate certain mandatory, and possibly discretionary, actions
by regulators that, if undertaken, could have a direct material effect on the
Company and the Bank's financial statements. Under capital adequacy guidelines
and the regulatory framework for prompt corrective action, the Company and the
Bank must meet specific capital guidelines that involve quantitative measures of
the Company and the Bank's assets, liabilities, and certain off-balance-sheet
items as calculated under regulatory accounting practices. The Company and the
Bank's capital amounts and classification are also subject to qualitative
judgments by the regulators about components, risk weightings, and other
factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Company and the Bank to maintain minimum amounts and ratios set
forth in the table below of Total and Tier I capital (as defined in the
regulations) to risk-weighted assets (as defined in the regulations), and of
Tier I capital (as defined in the regulations) to average assets (as defined in
the regulations). Management believes, as of December 31, 2003, that the Company
and the Bank meet all capital adequacy requirements to which they are subject.
As of September 30, 2003, the most recent notification from the Federal Reserve
Bank categorized the Company and the Bank as well capitalized under the
regulatory framework for prompt corrective action. To be categorized as well
capitalized, the Company and the Bank must maintain minimum Total risk-based,
Tier I risk-based, Tier I leverage ratios as set forth in the table below. There
are no conditions or events since that notification that management believes
have changed the institutions' categories.
To Be Well
Capitalized Under
Regulatory Capital Prompt Corrective
(in thousands) Actual Requirements Action Provisions
- ------------------------------------------------------------------------------------------------------------------
The Company: Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------
As of December 31, 2003
Total Capital to Risk Weighted Assets $132,751 13.24% $ 80,189 8.0% N/A N/A
Tier I Capital to Risk Weighted Assets $120,164 11.99% $ 40,095 4.0% N/A N/A
Tier I Capital to Average Assets $120,164 10.67% $ 45,036 4.0% N/A N/A
To Be Well
Capitalized Under
Regulatory Capital Prompt Corrective
(in thousands) Actual Requirements Action Provisions
- ------------------------------------------------------------------------------------------------------------------
The Bank: Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------
As of December 31, 2003
Total Capital to Risk Weighted Assets $123,825 12.39% $ 79,966 8.0% $ 99,958 10.0%
Tier I Capital to Risk Weighted Assets $111,272 11.13% $ 39,983 4.0% $ 59,975 6.0%
Tier I Capital to Average Assets $111,272 9.91% $ 44,908 4.0% $ 56,135 5.0%
As previously discussed (see Long-term Subordinated Debentures), in order to
supplement its regulatory capital base, during December, 2003 the Company raised
$10 million of trust preferred securities. See Note 19 of Notes to Consolidated
Financial Statements. Under applicable regulatory guidelines, trust preferred
securities qualify as Tier 1 capital up to a maximum of 25% of Tier 1 capital.
Any additional portion of trust preferred securities would qualify as Tier 2
capital. The Company has received notification from the Federal Reserve Bank of
San Francisco that all of the Company's trust preferred securities currently
qualify as Tier 1 capital.
43
During 2003, the Company repurchased 5,732 shares at an average share price of
$256 per share. In 2002, the Company repurchased 20,749 shares at an average
share price of $241.
OFF-BALANCE-SHEET ARRANGEMENTS AND AGGREGATE CONTRACTUAL OBLIGATIONS AND
COMMITMENTS
Off-balance-sheet arrangements are any contractual arrangement to which an
unconsolidated entity is a party, under which the Company has: (1) any
obligation under a guarantee contract; (2) a retained or contingent interest in
assets transferred to an unconsolidated entity or similar arrangement that
serves as credit, liquidity or market risk support to that entity for such
assets; (3) any obligation under certain derivative instruments; or (4) any
obligation under a material variable interest held by us in an unconsolidated
entity that provides financing, liquidity, market risk or credit risk support to
the Company, or engages in leasing, hedging or research and development services
with the Company.
Our most significant off-balance-sheet arrangements are limited to: (1) the full
and unconditional payment guarantee of accrued distributions relating to $10
million of Trust Preferred Securities issued by FMCB Statutory Trust (See Note
19 of the Consolidated Financial Statements); (2) derivative instruments indexed
to the Prime Rate (See Note 14 of the Consolidated Financial Statements); (3)
obligations under guarantee contracts such as financial and performance standby
letters of credit for our credit customers (See Note 15 of the Consolidated
Financial Statements); (4) commercial letters of credit (See Note 15 of the
Consolidated Financial Statements); (5) unfunded commitments to lend (See Note
15of the Consolidated Financial Statements); and (6) property lease contracts
(See Note 15 of the Consolidated Financial Statements). It is our belief that
none of these arrangements expose us to any greater risk of loss than is already
reflected on our balance sheet. We do not have any off-balance-sheet
arrangements in which we have any retained or contingent interest (as we do not
transfer or sell our assets to entities in which we have a continuing
involvement), any exposure to derivative instruments that are indexed to stock
indices nor any variable interests in any unconsolidated entity to which we may
be a party.
The following table presents, as of December 31, 2003, our significant and
determinable contractual obligations by payment date. The payment amounts
represent those amounts contractually due to the recipient and do not include
any unamortized premiums or discount, hedge basis adjustment or other similar
carrying value adjustments. For further information on the nature of each
obligation type, see applicable note disclosure in "Notes to Consolidated
Financial Statements".
Payments Due By Period
(in thousands)
- ---------------------------------------------------- ------------ ------------ ------------- ----------- -------------
Contractual Total Less than 1-3 Years 3-5 years More than
Obligations 1 Year 5 Years
- ---------------------------------------------------- ------------ ------------ ------------- ----------- -------------
Operating Lease Obligations $ 644 $ 251 $ 246 $ 93 $ 54
- ---------------------------------------------------- ------------ ------------ ------------- ----------- -------------
Other Long-Term Liabilities Reflected On the 10,310 - - - 10,310
Company's Balance Sheet under GAAP
- ---------------------------------------------------- ------------ ------------ ------------- ----------- -------------
Total $ 10,954 $ 251 $ 246 $ 93 $ 10,364
- ---------------------------------------------------- ------------ ------------ ------------- ----------- -------------
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Risk Management
The Company has adopted a Risk Management Plan which aims to ensure the proper
control and management of all risk factors inherent in the operation of the
Company and the Bank. Specifically, credit risk, interest rate risk, liquidity
risk, compliance risk, strategic risk, reputation risk and price risk can all
affect the market risk of the Company. These specific risk factors are not
mutually exclusive. It is recognized that any product or service offered by the
Company may expose the Company and the Bank to one or more of these risk
factors.
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Credit Risk
Credit risk is the risk to earnings or capital arising from an obligor's failure
to meet the terms of any contract or otherwise fail to perform as agreed. Credit
risk is found in all activities where success depends on counterparty, issuer or
borrower performance.
Credit risk in the investment portfolio and correspondent bank accounts is
addressed through defined limits in the Bank's policy statements. In addition,
certain securities carry insurance to enhance credit quality of the bond.
Credit risk in the loan portfolio is controlled by limits on industry
concentration, aggregate customer borrowings and geographic boundaries.
Standards on loan quality also are designed to reduce loan credit risk. Senior
Management, Directors' Committees, and the Board of Directors are regularly
provided with information intended to identify, measure, control and monitor the
credit risk of the Bank.
The Company's methodology for assessing the appropriateness of the allowance is
applied on a regular basis and considers all loans. The systematic methodology
consists of two major elements. The first major element includes a detailed
analysis of the loan portfolio in two phases. The first phase is conducted in
accordance with SFAS No. 114, "Accounting by Creditors for the Impairment of a
Loan" as amended by SFAS No. 118, "Accounting by Creditors for Impairment of a
Loan -- Income Recognition and Disclosures." Individual loans are reviewed to
identify loans for impairment. A loan is impaired when principal and interest
are deemed uncollectable in accordance with the original contractual terms of
the loan. Impairment is measured as either the expected future cash flows
discounted at each loan's effective interest rate, the fair value of the loan's
collateral if the loan is collateral dependent, or an observable market price of
the loan (if one exists). Upon measuring the impairment, the Company will ensure
an appropriate level of allowance is present or established.
Central to the first phase and the Company's credit risk management is its loan
risk rating system. The originating credit officer assigns borrowers an initial
risk rating, which is based primarily on a thorough analysis of each borrower's
financial position in conjunction with industry and economic trends. Approvals
are made based upon the amount of inherent credit risk specific to the
transaction and are reviewed for appropriateness by senior credit administration
personnel. Credits are monitored by credit administration personnel for
deterioration in a borrower's financial condition, which would impact the
ability of the borrower to perform under the contract. Risk ratings are adjusted
as necessary.
Based on the risk rating system specific allowances are established in cases
where management has identified significant conditions or circumstances related
to a credit that management believes indicates the possibility of loss.
Management performs a detailed analysis of these loans, including, but not
limited to, cash flows, appraisals of the collateral, conditions of the
marketplace for liquidating the collateral and assessment of the guarantors.
Management then determines the inherent loss potential and allocates a portion
of the allowance for losses as a specific allowance for each of these credits.
The second phase is conducted by segmenting the loan portfolio by risk rating
and into groups of loans with similar characteristics in accordance with SFAS
No. 5, "Accounting for Contingencies". In this second phase, groups of loans are
reviewed and applied the appropriate allowance percentage to determine a
portfolio formula allowance.
The second major element in the Company's methodology for assessing the
appropriateness of the allowance consists of management's considerations of all
known relevant internal and external factors that may affect a loan's
collectibility. This includes management's estimates of the amounts necessary
for concentrations, economic uncertainties, the volatility of the market value
of collateral and other relevant factors. The relationship of the two major
elements of the allowance to the total allowance may fluctuate from period to
period.
The second major element of the analysis, which considers all known relevant
internal and external factors that may affect a loan's collectibility, is based
upon management's evaluation of various conditions, the effects of which are not
directly measured in the determination of the formula and specific allowances.
The evaluation of the inherent loss with respect to these conditions is subject
to a higher degree of uncertainty because they are not identified with specific
problem credits or portfolio segments. The conditions evaluated in connection
with the second element of the analysis of the allowance include, but are not
limited to the following conditions that existed as of the balance sheet date:
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|X| then-existing general economic and business conditions affecting the key
lending areas of the Company;
|X| credit quality trends (including trends in non-performing loans expected to
result from existing conditions);
|X| collateral values;
|X| loan volumes and concentrations;
|X| seasoning of the loan portfolio;
|X| specific industry conditions within portfolio segments;
|X| recent loss experience in particular segments of the portfolio;
|X| duration of the current business cycle;
|X| bank regulatory examination results; and
|X| findings of the Company's internal credit examiners.
Management reviews these conditions in discussion with the Company's senior
credit officers. To the extent that any of these conditions is evidenced by a
specifically identifiable problem credit or portfolio segment as of the
evaluation date, management's estimate of the effect of such condition may be
reflected as a specific allowance applicable to such credit or portfolio
segment. Where any of these conditions is not evidenced by a specifically
identifiable problem credit or portfolio segment as of the evaluation date,
management's evaluation of the inherent loss related to such condition is
reflected in the second major element allowance.
Implicit in lending activities is the risk that losses will and do occur and
that the amount of such losses will vary over time. Consequently, the Company
maintains an allowance for loan losses by charging a provision for loan losses
to earnings. Loans determined to be losses are charged against the allowance for
loan losses. The Company's allowance for loan losses is maintained at a level
considered by management to be adequate to provide for estimated losses inherent
in the existing portfolio along with unused commitments to provide financing
including commitments under commercial and standby letters of credit.
Management believes that the allowance for loan losses at December 31, 2003 was
adequate to provide for both recognized losses and estimated inherent losses in
the portfolio. No assurances can be given that future events may not result in
increases in delinquencies, non-performing loans or net loan chargeoffs that
would increase the provision for loan losses and thereby adversely affect the
results of operations.
Market Risk - Interest Rate Risk
The mismatch between maturities of interest sensitive assets and liabilities
results in uncertainty in the Company's earnings and economic value and is
referred to as interest rate risk. The Company's primary objective in managing
interest rate risk is to minimize the potential for significant loss as a result
of changes in interest rates.
The Company measures interest rate risk in terms of potential impact on both its
economic value and earnings. The methods for governing the amount of interest
rate risk include: analysis of asset and liability mismatches (GAP analysis),
the utilization of a simulation model and limits on maturities of investment,
loan and deposit products which reduces the market volatility of those
instruments.
The Gap analysis measures, at specific time intervals, the divergence between
earning assets and interest bearing liabilities for which repricing
opportunities will occur. A positive difference, or Gap, indicates that earning
assets will reprice faster than interest-bearing liabilities. This will
generally produce a greater net interest margin during periods of rising
interest rates and a lower net interest margin during periods of declining
interest rates. Conversely, a negative gap will generally produce a lower net
interest margin during periods of rising interest rates and a greater net
interest margin during periods of decreasing interest rates.
The interest rates paid on deposit accounts do not always move in unison with
the rates charged on loans. In addition, the magnitude of changes in the rates
charged on loans is not always proportionate to the magnitude of changes in the
rate paid for deposits. Consequently, changes in interest rates do not
necessarily result in an increase or decrease in the net interest margin solely
as a result of the differences between repricing opportunities of earning assets
or interest bearing liabilities.
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The Company also utilizes the results of a dynamic simulation model to quantify
the estimated exposure of net interest income to sustained interest rate
changes. The sensitivity of the Company's net interest income is measured over a
rolling one-year horizon.
The simulation model estimates the impact of changing interest rates on interest
income from all interest earning assets and the interest expense paid on all
interest bearing liabilities reflected on the Company's balance sheet. This
sensitivity analysis is compared to policy limits, which specify a maximum
tolerance level for net interest income exposure over a one-year horizon
assuming no balance sheet growth, given a 200 basis point upward and a 100 basis
point downward shift in interest rates. A shift in rates over a 12-month period
is assumed. Results that exceed policy limits, if any, are analyzed for risk
tolerance and reported to the Board with appropriate recommendations. At
December 31, 2003, the Company's estimated net interest income sensitivity to
changes in interest rates, as a percent of net interest income was an increase
in net interest income of 2.43% if rates increase by 200 basis points and a
decrease in net interest income of 1.11% if rates decline 100 basis points.
The estimated sensitivity does not necessarily represent a Company forecast and
the results may not be indicative of actual changes to the Company's net
interest income. These estimates are based upon a number of assumptions
including: the nature and timing of interest rate levels including yield curve
shape, prepayments on loans and securities, pricing strategies on loans and
deposits, replacement of asset and liability cashflows, and other assumptions.
While the assumptions used are based on current economic and local market
conditions, there is no assurance as to the predictive nature of these
conditions including how customer preferences or competitor influences might
change. See Note 13 of the Notes to the Consolidated Financial Statements.
Liquidity Risk
Liquidity risk is the risk to earnings or capital resulting from the Bank's
inability to meet its obligations when they come due without incurring
unacceptable losses. It includes the ability to manage unplanned decreases or
changes in funding sources and to recognize or address changes in market
conditions that affect the Bank's ability to liquidate assets or acquire funds
quickly and with minimum loss of value. The Company endeavors to maintain a cash
flow adequate to fund operations, handle fluctuations in deposit levels, respond
to the credit needs of borrowers and to take advantage of investment
opportunities as they arise. The principal sources of liquidity include credit
facilities from correspondent banks, brokerage firms and the Federal Home Loan
Bank, as well as, interest and principal payments on loans and investments,
proceeds from the maturity or sale of investments, and growth in deposits.
In general, liquidity risk is managed daily by controlling the level of Federal
Funds and the use of funds provided by the cash flow from the investment
portfolio. The Company maintains overnight investments in Federal Funds as a
cushion for temporary liquidity needs. During 2003, Federal Funds averaged $15.9
million. The Company maintains Federal Fund credit lines of $50 million with
major banks subject to the customary terms and conditions for such arrangements
and $175 million in repurchase lines with major brokers. In addition the Company
has additional borrowing capacity of $145 million from the Federal Home Loan
Bank.
At December 31, 2003, the Company had available liquid assets, which included
cash and cash equivalents and unpledged investment securities of approximately
$186 million, which represents 16.2% of total assets.
CONTROLS AND PROCEDURES
The Company maintains controls and procedures designed to ensure that all
relevant information is recorded and reported in all filings of financial
reports. Such information is reported to the Company's management, including its
Chief Executive Officer and its Chief Financial Officer to allow timely and
accurate disclosure based on the definition of "disclosure controls and
procedures" in Rule 13a-14(c). In designing these controls and procedures,
management recognizes that they can only provide reasonable assurance of
achieving the desired control objectives. Management also evaluated the
cost-benefit relationship of possible controls and procedures.
Within 90 days prior to the date of this report, the Company carried out an
evaluation of the effectiveness of Company's controls and disclosure procedures
under the supervision and with the participation of the Chief Executive Officer,
the Chief Financial Officer and other senior management of the Company. Based on
the foregoing, the Company's Chief Executive Officer and the Chief Financial
Officer concluded that the Company's disclosure controls and procedures were
effective.
47
There have been no significant changes in the Company's internal controls or in
other factors that could significantly affect the internal controls subsequent
to the date the Company completed its evaluation.
Available Information
Company reports filed with the Securities and Exchange Commission (the
"Commission") including the annual report on Form 10-K, quarterly reports on
Form 10-Q, current reports on Form 8-K, proxy statements and other information
can be accessed through the Company's web site. The Company web address is
http://www.fmbonline.com. The link to the Securities and Exchange Commission is
on the About F & M Bank page.
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