Edgar Filing: SIERRA BANCORP

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES

EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2014

Commission file number: 000-33063

Sierra Bancorp

(Exact name of Registrant as specified in its charter)

California	33-0937517
(State of Incorporation)	(IRS Employer Identification No)

86 North Main Street, Porterville, California 93257

(Address of principal executive offices) (Zip Code)

(559) 782-4900

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes R No ¨

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes R No ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.

Large accelerated filer ¨	Accelerated filer R
Non-accelerated filer ¨ (Do not check if a smaller reporting company)	Smaller Reporting Company ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes ¨ No R

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Common stock, no par value, 13,787,587 shares outstanding as of October 31, 2014

FORM 10-Q

Table of Contents

	Page
Part I - Financial Information	1
Item 1. Financial Statements (Unaudited)	1
Consolidated Balance Sheets	1
Consolidated Statements of Income	2
Consolidated Statements of Comprehensive Income	3
Consolidated Statements of Cash Flows	4
Notes to Unaudited Consolidated Financial Statements	5

Item 2. Management’s Discussion & Analysis of Financial Condition & Results of Operations	30
Forward-Looking Statements	30
Critical Accounting Policies	30
Overview of the Results of Operations and Financial Condition	31
Earnings Performance	32
Net Interest Income and Net Interest Margin	32
Provision for Loan and Lease Losses	36
Non-interest Income and Non-Interest Expense	37
Provision for Income Taxes	40
Balance Sheet Analysis	40
Earning Assets	40
Investments	40
Loan and Lease Portfolio	42
Nonperforming Assets	43
Allowance for Loan and Lease Losses	44
Off-Balance Sheet Arrangements	46
Other Assets	46
Deposits and Interest-Bearing Liabilities	47
Deposits	47
Other Interest-Bearing Liabilities	48
Non-Interest Bearing Liabilities	48
Liquidity and Market Risk Management	48
Capital Resources	51

Item 3. Qualitative & Quantitative Disclosures about Market Risk	52

Item 4. Controls and Procedures	52

Part II - Other Information	53
Item 1. - Legal Proceedings	53
Item 1A. - Risk Factors	53
Item 2. - Unregistered Sales of Equity Securities and Use of Proceeds	53
Item 3. - Defaults upon Senior Securities	53
Item 4. - (Removed and Reserved)	53
Item 5. - Other Information	53
Item 6. - Exhibits	54

Signatures	55

PART I - FINANCIAL INFORMATION

Item 1 – Financial Statements

SIERRA BANCORP

CONSOLIDATED BALANCE SHEETS

(dollars in thousands)

	September 30, 2014			December 31, 2013
	(unaudited)			(audited)
ASSETS
Cash and due from banks	$	37,179		$	51,342
Interest-bearing deposits in banks		2,499			26,664
Total cash & cash equivalents		39,678			78,006
Investment securities available for sale		467,688			425,044
Loans held for sale		-			105
Loans and leases:
Gross loans and leases		883,675			803,242
Allowance for loan and lease losses		(11,012	)		(11,677	)
Deferred loan and lease fees, net		1,506			1,522
Net loans and leases		874,169			793,087
Premises and equipment, net		20,982			20,393
Foreclosed assets		4,719			8,185
Goodwill		5,544			5,544
Other assets		76,244			79,885
TOTAL ASSETS	$	1,489,024		$	1,410,249

LIABILITIES AND SHAREHOLDERS' EQUITY
LIABILITIES
Deposits:
Non-interest bearing	$	361,388		$	365,997
Interest bearing		861,658			808,182
Total deposits		1,223,046			1,174,179
Federal funds purchased and repurchase agreements		7,170			5,974
Short-term borrowings		22,390			-
Junior subordinated debentures		30,928			30,928
Other liabilities		19,250			17,494
TOTAL LIABILITIES		1,302,784			1,228,575
SHAREHOLDERS' EQUITY
Common stock, no par value; 24,000,000 shares authorized; 13,841,342 and 14,217,199 shares issued and outstanding at September 30, 2014 and December 31, 2013, respectively		64,649			65,780
Additional paid in capital		2,526			2,648
Retained earnings		115,712			112,817
Accumulated other comprehensive income		3,353			429
TOTAL SHAREHOLDERS' EQUITY		186,240			181,674

TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY	$	1,489,024		$	1,410,249

The accompanying notes are an integral part of these consolidated financial statements

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF INCOME

(dollars in thousands, except per share data, unaudited)

	Three months ended September 30,				Nine months ended September 30,
	2014		2013		2014		2013
Interest income:
Interest and fees on loans	$	11,237	$	10,932	$	32,644	$	33,207
Interest on investment securities:
Taxable		2,008		1,132		5,709		3,328
Non-Taxable		729		699		2,203		1,990
Interest on federal funds sold and interest-bearing deposits		4		28		55		72
Total interest income		13,978		12,791		40,611		38,597

Interest expense:
Interest on deposits		503		606		1,614		1,894
Interest on short-term borrowings		6		4		16		16
Interest on long-term borrowings		-		-		-		33
Interest on mandatorily redeemable trust preferred securities		177		180		526		536
Total interest expense		686		790		2,156		2,479

Net Interest Income		13,292		12,001		38,455		36,118

Provision for loan losses		-		800		350		2,850

Net Interest Income after Provision for Loan Losses		13,292		11,201		38,105		33,268

Non-interest income:
Service charges on deposit accounts		2,214		2,354		6,139		6,642
Gains on investment securities available-for-sale		-		-		287		6
Other income, net		1,571		1,965		5,084		5,808
Total non-interest income		3,785		4,319		11,510		12,456

Non-interest expense:
Salaries and employee benefits		5,459		5,394		16,772		16,717
Occupancy expense		1,662		1,554		4,700		4,702
Other		4,629		4,542		12,014		12,608
Total non-interest expense		11,750		11,490		33,486		34,027

Income before income taxes		5,327		4,030		16,129		11,697

Provision for income taxes		1,776		663		4,543		2,198

Net Income	$	3,551	$	3,367	$	11,586	$	9,499

PER SHARE DATA
Book value	$	13.46	$	12.54	$	13.46	$	12.54
Cash dividends	$	0.09	$	0.07	$	0.25	$	0.19
Earnings per share basic	$	0.25	$	0.24	$	0.82	$	0.67
Earnings per share diluted	$	0.25	$	0.23	$	0.81	$	0.67
Average shares outstanding, basic		13,939,152		14,176,732		14,083,649		14,139,697
Average shares outstanding, diluted		14,072,783		14,329,177		14,217,150		14,256,782

Total shareholder equity (in thousands)	$	186,240	$	178,056	$	186,240	$	178,056
Shares outstanding		13,841,342		14,194,659		13,841,342		14,194,659
Dividends Paid	$	1,260,823	$	991,908	$	3,528,478	$	2,685,932

The accompanying notes are an integral part of these consolidated financial statements

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(dollars in thousands, unaudited)

	Three months ended September 30,						Nine months ended September 30,
	2014			2013			2014			2013

Net Income	$	3,551		$	3,367		$	11,586		$	9,499
Other comprehensive income, before tax:
Unrealized gains on securities:
Unrealized holding (losses) gains arising during period		(237	)		(100	)		5,256			(6,342	)
Less: reclassification adjustment for gains ⁽¹⁾		-			-			(287	)		(6	)
Other comprehensive (loss) income, before tax		(237	)		(100	)		4,969			(6,348	)
Income tax expense (benefit) related to items of other comprehensive income (loss), net of tax		97			41			(2,045	)		2,613
Other comprehensive income (loss) gain		(140	)		(59	)		2,924			(3,735	)

Comprehensive Income	$	3,411		$	3,308		$	14,510		$	5,764

⁽¹⁾ Amounts are included in net gains on investment securities available-for-sale on the Consolidated Statements of Income in non-interest revenue. Income tax expense associated with the reclassification adjustment for the nine months ended September 30, 2014 and 2013 was $118 thousand and $2 thousand respectively.

The accompanying notes are an integral part of these consolidated financial statements

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands, unaudited)

	Nine months ended September 30,
	2014			2013
Cash flows from operating activities:
Net income	$	11,586		$	9,499
Adjustments to reconcile net income to net cash provided by operating activities:
Gain on sales of securities		(287	)		(6	)
Gain on sales of loans		(3	)		(92	)
Loss (gain) on disposal of fixed assets		1			(15	)
(Gain) loss on sale on foreclosed assets		(531	)		568
Writedowns on foreclosed assets		286			695
Share-based compensation expense		57			218
Provision for loan losses		350			2,850
Depreciation		1,569			1,639
Net amortization on securities premiums and discounts		4,925			6,441
Increase in unearned net loan fees		(16	)		(90	)
Increase in cash surrender value of life insurance policies		(1,001	)		(1,389	)
Proceeds from sales of loans portfolio		108			3,662
Increase in loans held-for-sale		-			(3,627	)
Decrease in interest receivable and other assets		1,923			3,119
Decrease in other liabilites		1,756			1,161
Net (increase) decrease in FHLB stock		(190	)		438
Deferred income tax provision		864			378
Excess tax benefit from equity based compensation		-			(253	)
Net cash provided by operating activities		21,397			25,196

Cash flows from investing activities:
Maturities of securities available for sale		995			1,399
Proceeds from sales/calls of securities available for sale		11,055			3,454
Purchases of securities available for sale		(111,425	)		(120,352	)
Principal pay downs on securities available for sale		57,062			76,815
Net (increase) decrease in loans receivable, net		(82,126	)		61,039
Purchases of premises and equipment, net		(2,159	)		(275	)
Proceeds from sales of foreclosed assets		4,421			13,116
Net cash (used in) provided by investing activities		(122,177	)		35,196

Cash flows from financing activities:
Increase (decrease) in deposits		48,867			(22,556	)
Increase (decrease) in borrowed funds		22,390			(41,650	)
Increase in repurchase agreements		1,196			4,277
Cash dividends paid		(3,528	)		(2,686	)
Repurchases of common stock		(7,284	)		-
Stock options exercised		811			1,121
Excess tax benefit from equity based compensation		-			253
Net cash provided by (used in) financing activities		62,452			(61,241	)

Decrease in cash and due from banks		(38,328	)		(849	)

Cash and cash equivalents
Beginning of period		78,006			61,818
End of period	$	39,678		$	60,969

The accompanying notes are an integral part of these consolidated financial statements

Sierra Bancorp

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2014

Note 1 – The Business of Sierra Bancorp

Sierra Bancorp (the “Company”) is a California corporation headquartered in Porterville, California, and is a registered bank holding company under federal banking laws. The Company was formed to serve as the holding company for Bank of the Sierra (the “Bank”), and has been the Bank’s sole shareholder since August 2001. The Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish. At the present time, the Company’s only other subsidiaries are Sierra Statutory Trust II and Sierra Capital Trust III, which were formed in March 2004 and June 2006, respectively, solely to facilitate the issuance of capital trust pass-through securities (TRUPS). Pursuant to the Financial Accounting Standards Board’s (FASB’s) standard on the consolidation of variable interest entities, these trusts are not reflected on a consolidated basis in the Company’s financial statements. References herein to the “Company” include Sierra Bancorp and its consolidated subsidiary, the Bank, unless the context indicates otherwise.

The Bank is a California state-chartered bank headquartered in Porterville, California, that offers a full range of retail and commercial banking services primarily to communities in the central and southern regions of the San Joaquin Valley. Our branch footprint stretches from Fresno on the north to Bakersfield on the south, and on the southern end extends east through the Tehachapi plateau and into the northwestern tip of the Mojave Desert. The Bank was incorporated in September 1977 and opened for business in January 1978, and in the ensuing years has grown to be the largest independent bank headquartered in the South San Joaquin Valley. Our growth has primarily been organic, but includes the acquisition of Sierra National Bank in 2000. We currently operate 25 full service branch offices throughout our geographic footprint, as well as an internet branch which provides the ability to open deposit accounts online. The Bank has received regulatory approval for another branch in Bakersfield, California, which is expected to commence operations in the first quarter of 2015. In addition to our full-service branches the Bank has specialized lending units which include a real estate industries center, an agricultural credit center, and an SBA lending unit, and we operate offsite ATMs at six different non-branch locations. The Bank’s deposit accounts are insured by the Federal Deposit Insurance Corporation (FDIC) up to maximum insurable amounts.

On July 17, 2014 the Company entered into a definitive agreement to acquire Santa Clara Valley Bank (OTC: SCVE) of Santa Paula, California, a community bank with $129 million in assets and branches located in Santa Paula, Santa Clarita, and Fillmore, California. The agreement calls for the payment of cash consideration of $12.3 million, or $6.00 per share, to SCVE’s common shareholders and cash consideration of $3.0 million to SCVE’s preferred shareholders to retire outstanding preferred stock and associated warrants. Included in the $12.3 million payment is $700,000 that the Company will pay to cash out existing in-the-money warrants. All requisite regulatory approvals have been received, and the acquisition was approved by the shareholders of Santa Clara Valley Bank at a special meeting held October 29, 2014. The transaction is expected to close in the fourth quarter of 2014. One-time acquisition costs totaled $267,000 in the third quarter of 2014, and if the transaction is consummated in the anticipated time frame management has projected that they will add around $2.0 million to Sierra Bancorp’s pre-tax non-interest expense in the fourth quarter of 2014.

Note 2 – Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in a condensed format, and therefore do not include all of the information and footnotes required by US generally accepted accounting principles (GAAP) for complete financial statements. The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such period. Such adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. In preparing the accompanying consolidated financial statements, management has taken subsequent events into consideration and recognized them where appropriate. The results of operations in the interim statements are not necessarily indicative of the results that may be expected for any other quarter, or for the full year. Certain amounts reported for 2013 have been reclassified to be consistent with the reporting for 2014. The interim financial information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, as filed with the Securities and Exchange Commission.

Note 3 – Current Accounting Developments

In May 2014, the FASB issued Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (Topic 606). This ASU is the result of a joint project initiated by the FASB and the International Accounting Standards Board (IASB) to clarify the principles for recognizing revenue, and to develop a common revenue standard and disclosures for U.S. and international accounting standards that would: (1) remove inconsistencies and weaknesses in revenue requirements; (2) provide a more robust framework for addressing revenue issues; (3) improve comparability of revenue recognition practices across entities, industries, jurisdictions, and capital markets; (4) provide more useful information to users of financial statements through improved disclosure requirements; and (5) simplify the preparation of financial statements by reducing the number of requirements to which an entity must refer. The guidance affects any entity that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets. The core principle is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The guidance provides steps to follow to achieve the core principle. An entity should disclose sufficient information to enable users of financial statements to understand the nature, amount, timing and uncertainty of revenue and cash flows arising from contracts with customers. Qualitative and quantitative information is required with regard to contracts with customers, significant judgments and changes in judgments, and assets recognized from the costs to obtain or fulfill a contract. This ASU is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. The Company is currently evaluating the potential effects of this guidance on its financial statements and disclosures.

In January 2014, the FASB issued ASU 2014-01, Investments—Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects, to provide additional flexibility with regard to accounting for investments in qualified affordable housing projects. ASU 2014-01 modifies the conditions that must be met to present the pretax impact and related tax benefits of such investments as a component of income taxes (“net” within income tax expense), to enable more investors to elect to use a “net” presentation for those investments. Investors that do not qualify for “net” presentation under the new guidance will continue to account for such investments under the equity method or cost method, which results in losses recognized in pretax income and tax benefits recognized in income taxes (“gross” presentation of investment results). For investments that qualify for the “net” presentation of investment performance, ASU 2014-01 introduces a “proportional amortization method” that can be elected to amortize the investment basis. If elected, the method is required for all eligible investments in qualified affordable housing projects. ASU 2014-01 also requires enhanced recurring disclosures for all investments in qualified affordable housing projects, regardless of the accounting method used for those investments. It is effective for interim and annual periods beginning after December 15, 2014, and early adoption is permitted. The Company currently expects to adopt ASU 2014-01 as of the first quarter of 2015. We will likely continue to account for our low-income housing tax credit investments using the equity method subsequent to our adoption of ASU 2014-01 and thus do not expect any impact on our income statement or balance sheet, but our disclosures with regard to low-income housing tax credit investments will be updated to reflect the new requirements.

In January 2014, the FASB issued ASU 2014-04, Receivables—Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure, to resolve diversity in practice with respect to a creditor’s reclassification of a collateralized consumer mortgage loan to other real estate owned (OREO). Current US GAAP requires a loan to be reclassified to OREO upon a troubled debt restructuring that is “in substance a repossession or foreclosure”, where the creditor receives “physical possession” of the debtor's assets regardless of whether formal foreclosure proceedings take place. The terms “in substance a repossession or foreclosure” and “physical possession” are not defined in US GAAP; therefore, questions have arisen about when a creditor should reclassify a collateralized mortgage loan to OREO. ASU 2014-04 requires a creditor to reclassify a collateralized consumer mortgage loan to real estate property upon obtaining legal title to the real estate collateral, or when the borrower voluntarily conveys all interest in the real estate property to the lender to satisfy the loan through a deed in lieu of foreclosure or similar legal agreement. ASU 2014-04 is effective for public business entities for interim and annual periods beginning after December 15, 2014. It will be adopted by the Company for the first quarter of 2015, and we do not expect any impact upon our financial statements or operations upon adoption.

Note 4 – Supplemental Disclosure of Cash Flow Information

During the nine months ended September 30, 2014 and 2013, cash paid for interest due on interest-bearing liabilities was $2.219 million and $2.621 million, respectively. There was $160,000 in cash paid for income taxes during the nine months ended September 30, 2014, but no cash paid for income taxes for the nine months ended September 30, 2013. Assets totaling $184,000 and $4.068 million were acquired in settlement of loans for the nine months ended September 30, 2014 and September 30, 2013, respectively. We received $4.421 million in cash from the sale of foreclosed assets during the first nine months of 2014 relative to $11.926 million during the first nine months of 2013, which represents sales proceeds less loans extended to finance such sales.

Note 5 – Share Based Compensation

The 2007 Stock Incentive Plan (the “2007 Plan”) was adopted by the Company in 2007. Our 1998 Stock Option Plan (the “1998 Plan”) was concurrently terminated, although options to purchase 122,000 shares that were granted under the 1998 Plan were still outstanding as of September 30, 2014 and remain unaffected by that plan’s termination. The 2007 Plan provides for the issuance of both “incentive” and “nonqualified” stock options to officers and employees, and of “nonqualified” stock options to non-employee directors of the Company. The 2007 Plan also provides for the potential issuance of restricted stock awards to these same classes of eligible participants, on such terms and conditions as are established at the discretion of the Board of Directors or the Compensation Committee. The total number of shares of the Company’s authorized but unissued stock reserved for issuance pursuant to awards under the 2007 Plan was initially 1,500,000 shares, although the number remaining available for grant as of September 30, 2014 was 838,560. The dilutive impact of stock options outstanding is discussed below in Note 6, Earnings per Share. No restricted stock awards have been issued by the Company.

Pursuant to FASB’s standards on stock compensation, the value of each option granted is reflected in our income statement as employee compensation or directors’ expense by amortizing the value over the vesting period of such option or by expensing it as of the grant date for immediately vested options. The Company is utilizing the Black-Scholes model to value stock options, and the “multiple option” approach is used to allocate the resulting valuation to actual expense. Under the multiple option approach an employee’s options for each vesting period are separately valued and amortized, which appears to be the preferred method for option grants with graded vesting. A charge of $24,000 was reflected in the Company’s income statement during the third quarter of 2014 and $67,000 was charged during the third quarter of 2013, as expense related to stock options. For the first nine months, the charges totaled $57,000 in 2014 and $218,000 in 2013.

Note 6 – Earnings per Share

The computation of earnings per share, as presented in the Consolidated Statements of Income, is based on the weighted average number of shares outstanding during each period. There were 13,939,152 weighted average shares outstanding during the third quarter of 2014, and 14,176,732 during the third quarter of 2013. There were 14,083,649 weighted average shares outstanding during the first nine months of 2014, and 14,139,697 during the first nine months of 2013.

Diluted earnings per share include the effect of the potential issuance of common shares, which for the Company is limited to shares that would be issued on the exercise of “in-the-money” stock options. The dilutive effect of options outstanding was calculated using the treasury stock method, excluding anti-dilutive shares and adjusting for unamortized expense and windfall tax benefits. For the third quarter and first nine months of 2014 the dilutive effect of options outstanding calculated under the treasury stock method totaled 133,631 shares and 133,501 shares, respectively, which were added to basic weighted average shares outstanding for purposes of calculating diluted earnings per share. Likewise, for the third quarter and first nine months of 2013 shares totaling 152,445 and 117,085, respectively, were added to basic weighted average shares outstanding in order to calculate diluted earnings per share.

Note 7 – Comprehensive Income

As presented in the Consolidated Statements of Comprehensive Income, comprehensive income includes net income and other comprehensive income. The Company’s only source of other comprehensive income is unrealized gains and losses on available-for-sale investment securities. Gains or losses on investment securities that were realized and included in net income of the current period, which had previously been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose, are considered to be reclassification adjustments that are excluded from other comprehensive income in the current period.

Note 8 – Financial Instruments with Off-Balance-Sheet Risk

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business, in order to meet the financing needs of its customers. Those financial instruments consist of unused commitments to extend credit and standby letters of credit. They involve, to varying degrees, elements of risk in excess of the amount recognized in the balance sheet. The Company’s exposure to credit loss in the event of nonperformance by counterparties for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and issuing letters of credit as it does for originating loans included on the balance sheet. The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):

	September 30, 2014		December 31, 2013
Commitments to extend credit	$	395,368	$	420,707
Standby letters of credit	$	6,871	$	8,703
Commercial letters of credit	$	7,592	$	8,070

Commitments to extend credit consist primarily of the unused or unfunded portions of the following: home equity lines of credit; commercial real estate construction loans, where disbursements are made over the course of construction; commercial revolving lines of credit; mortgage warehouse lines of credit; unsecured personal lines of credit; and formalized (disclosed) deposit account overdraft lines. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments are expected to expire without being drawn upon, the unused portions of committed amounts do not necessarily represent future cash requirements.

Standby letters of credit are generally unsecured and are issued by the Company to guarantee the performance of a customer to a third party, while commercial letters of credit represent the Company’s commitment to pay a third party on behalf of a customer upon fulfillment of contractual requirements. The credit risk involved in issuing letters of credit is essentially the same as the risk involved in extending loans to customers.

The Company is also utilizing an $88 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain deposits. The letter of credit is backed by loans which are pledged to the Federal Home Loan Bank by the Company.

Note 9 – Fair Value Disclosures and Reporting, the Fair Value Option and Fair Value Measurements

FASB’s standards on financial instruments, and on fair value measurements and disclosures, require all entities to disclose in their financial statement footnotes the estimated fair values of financial instruments for which it is practicable to estimate fair values. In addition to disclosure requirements, FASB’s standard on investments requires that our debt securities, which are classified as available for sale, and our equity securities that have readily determinable fair values, be measured and reported at fair value in our statement of financial position. Certain impaired loans are also reported at fair value, as explained in greater detail below, and foreclosed assets are carried at the lower of cost or fair value. FASB’s standard on financial instruments permits companies to report certain other financial assets and liabilities at fair value, but we have not elected the fair value option for any additional financial assets or liabilities.

Fair value measurements and disclosure standards also establish a framework for measuring fair values. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants on the measurement date. Further, the standards establish a fair value hierarchy that encourages an entity to maximize the use of observable inputs and limit the use of unobservable inputs when measuring fair values. The standards describe three levels of inputs that may be used to measure fair values:

	·	Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the factors that market participants would likely consider in pricing an asset or liability.

Fair value estimates are made at a specific point in time based on relevant market data and information about the financial instruments. The estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments. In addition, the tax ramifications related to realized gains and losses could have a significant effect on fair value estimates but have not been considered in any estimates. Because no market exists for a significant portion of the Company’s financial instruments, fair value disclosures are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors. The estimates are subjective and involve uncertainties and matters of significant judgment, and therefore cannot be determined with precision. Changes in assumptions could significantly affect the fair values presented. The following methods and assumptions were used by the Company to estimate the fair value of its financial instruments disclosed at September 30, 2014 and December 31, 2013:

	·	Cash and cash equivalents and fed funds sold: The carrying amount is estimated to be fair value.

	·	Investment securities: Fair values are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on their relationship to other benchmark quoted securities when quoted prices for specific securities are not readily available.

	·	Loans and leases: For variable-rate loans and leases that re-price frequently with no significant change in credit risk or interest rate spread, fair values are based on carrying values. Fair values for other loans and leases are estimated by discounting projected cash flows at interest rates being offered at each reporting date for loans and leases with similar terms, to borrowers of comparable creditworthiness. The carrying amount of accrued interest receivable approximates its fair value.

	·	Loans held for sale: Since loans designated by the Company as available-for-sale are typically sold shortly after making the decision to sell them, realized gains or losses are usually recognized within the same period and fluctuations in fair values are not relevant for reporting purposes. If available-for-sale loans are on our books for an extended period of time, the fair value of those loans is determined using quoted secondary-market prices.

	·	Collateral-dependent impaired loans: Collateral-dependent impaired loans are carried at fair value when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the original loan agreement and the loan has been written down to the fair value of its underlying collateral, net of expected disposition costs where applicable.

	·	Cash surrender value of life insurance policies: Fair values are based on net cash surrender values at each reporting date.

	·	Investments in, and capital commitments to, limited partnerships: The fair values of our investments in WNC Institutional Tax Credit Fund Limited Partnerships and any other limited partnerships are estimated using quarterly indications of value provided by the general partner. The fair values of undisbursed capital commitments are assumed to be the same as their book values.

	·	Other investments: Certain investments for which no secondary market exists are carried at cost unless an impairment analysis indicates the need for adjustments, and the carrying amount for those investments approximates their estimated fair value.

	·	Deposits: Fair values for non-maturity deposits are equal to the amount payable on demand at the reporting date, which is the carrying amount. Fair values for fixed-rate certificates of deposit are estimated using a cash flow analysis, discounted at interest rates being offered at each reporting date by the Bank for certificates with similar remaining maturities. The carrying amount of accrued interest payable approximates its fair value.

Short-term borrowings: The carrying amounts approximate fair values for federal funds purchased, overnight FHLB advances, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days of the reporting dates. Fair values of other short-term borrowings are estimated by discounting projected cash flows at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

	·	Long-term borrowings: Fair values are estimated using projected cash flows discounted at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

	·	Subordinated debentures: Fair values are determined based on the current market value for like instruments of a similar maturity and structure.

Commitments to extend credit and letters of credit: If funded, the carrying amounts for currently unused commitments would approximate fair values for the newly created financial assets at the funding date. However, because of the high degree of uncertainty with regard to whether or not those commitments will ultimately be funded, fair values for loan commitments and letters of credit in their current undisbursed state cannot reasonably be estimated, and only notional values are disclosed in the table below.

Estimated fair values for the Company’s financial instruments are as follows, as of the dates noted:

Fair Value of Financial Instruments
(dollars in thousands, unaudited)	September 30, 2014
			Estimated Fair Value
	Carrying Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Financial assets:
Cash and cash equivalents	$	39,678	$	39,678	$	-	$	-	$	39,678
Investment securities available for sale		467,688		2,562		465,126		-		467,688
Loans and leases, net held for investment		858,309		-		869,307		-		869,307
Collateral dependent impaired loans		15,860		-		15,860		-		15,860
Loans held-for-sale		-		-		-		-		-
Cash surrender value of life insurance policies		40,425		-		40,425		-		40,425
Other investments		6,122		-		6,122		-		6,122
Investment in limited partnership		7,579		-		7,579		-		7,579
Accrued interest receivable		5,248		-		5,248		-		5,248

Financial liabilities:
Deposits:
Noninterest-bearing	$	361,388	$	361,388	$	-	$	-	$	361,388
Interest-bearing		861,658		-		861,857		-		861,857
Fed funds purchased and repurchase agreements		7,170		-		7,170		-		7,170
Short-term borrowings		22,390		-		22,390		-		22,390
Long-term borrowings		-		-		-		-		-
Subordinated debentures		30,928		-		11,347		-		11,347
Limited partnership capital commitment		914		-		914		-		914
Accrued interest payable		122		-		122		-		122

	Notional Amount
Off-balance-sheet financial instruments:
Commitments to extend credit	$	395,368
Standby letters of credit		6,871
Commercial lines of credit		7,592

	December 31, 2013
			Estimated Fair Value
	Carrying Amount		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Financial assets:
Cash and cash equivalents	$	78,006	$	78,006	$	-	$	-	$	78,006
Investment securities available for sale		425,044		2,456		422,588		-		425,044
Loans and leases, net held for investment		778,382		-		797,383		-		797,383
Collateral dependent impaired loans		14,705		-		14,705		-		14,705
Loans held-for-sale		105		105		-		-		105
Cash surrender value of life insurance policies		39,424		-		39,424		-		39,424
Other Investments		5,932		-		5,932		-		5,932
Investment in limited partnership		9,204		-		9,204		-		9,204
Accrued interest receivable		4,990		-		4,990		-		4,990

Financial liabilities:
Deposits:
Noninterest-bearing	$	365,997	$	365,997	$	-	$	-	$	365,997
Interest-bearing		808,182		-		808,182		-		808,182
Fed funds purchased and repurchase agreements		5,974		-		5,974		-		5,974
Short-term borrowings		-		-		-		-		-
Long-term borrowings		-		-		-		-		-
Subordinated debentures		30,928		-		11,175		-		11,175
Limited partnership capital commitment		962		-		962		-		962
Accrued interest payable		186		-		186		-		186

	Notional Amount
Off-balance-sheet financial instruments:
Commitments to extend credit	$	420,707
Standby letters of credit		8,703
Commercial lines of credit		8,070

For financial asset categories that were actually reported at fair value at September 30, 2014 and December 31, 2013, the Company used the following methods and significant assumptions:

	·	Investment securities: Fair values are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on their relationship to other benchmark quoted securities.

	·	Collateral-dependent impaired loans: Collateral-dependent impaired loans are carried at fair value when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the original loan agreement and the loan has been written down to the fair value of its underlying collateral, net of expected disposition costs where applicable.

Foreclosed assets: Repossessed real estate (OREO) and other foreclosed assets are carried at the lower of cost or fair value. Fair value is the appraised value less expected selling costs for OREO and some other assets such as mobile homes, and for any other foreclosed assets fair value is represented by the estimated sales proceeds as determined using reasonably available sources. Foreclosed assets for which appraisals can be feasibly obtained are periodically measured for impairment using updated appraisals. Fair values for other foreclosed assets are adjusted as necessary, subsequent to a periodic re-evaluation of expected cash flows and the timing of resolution. If impairment is determined to exist, the book value of a foreclosed asset is immediately written down to its estimated impaired value through the income statement, thus the carrying amount is equal to the fair value and there is no valuation allowance.

Assets reported at fair value on a recurring basis are summarized below:

Fair Value Measurements - Recurring
(dollars in thousands, unaudited)
	Fair Value Measurements at September 30, 2014, using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Investment securities
US Government agencies	$	-	$	4,389	$	-	$	4,389
Mortgage-backed securities		-		362,114		-		362,114
State and poltical subdivisions		-		98,623		-		98,623
Equity securities		2,562		-		-		2,562

Total available-for-sale securities	$	2,562	$	465,126	$	-	$	467,688

	Fair Value Measurements at December 31, 2013, using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Investment securities
US Government agencies	$	-	$	5,304	$	-	$	5,304
Mortgage-backed securities		-		320,721		-		320,721
State and poltical subdivisions		-		96,563		-		96,563
Equity securities		2,456		-		-		2,456

Total available-for-sale securities	$	2,456	$	422,588	$	-	$	425,044

Assets reported at fair value on a nonrecurring basis are summarized below:

Fair Value Measurements - Nonrecurring
(dollars in thousands, unaudited)
	Fair Value Measurements at September 30, 2014, using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Collateral dependent impaired loans	$	-	$	15,860	$	-	$	15,860
Foreclosed assets	$	-	$	4,719	$	-	$	4,719

	Fair Value Measurements at December 31, 2013, using
	Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total
Collateral dependent impaired loans	$	-	$	14,705	$	-	$	14,705
Foreclosed assets	$	-	$	8,185	$	-	$	8,185

The table above includes collateral-dependent impaired loan balances for which a specific reserve has been established or on which a write-down has been taken. Information on the Company’s total impaired loan balances, and specific loss reserves associated with those balances, is included in Note 11 below, and in Management’s Discussion and Analysis of Financial Condition and Results of Operation in the “Nonperforming Assets” and “Allowance for Loan and Lease Losses” sections.

The unobservable inputs are based on management’s best estimates of appropriate discounts in arriving at fair market value. Increases or decreases in any of those inputs could result in a significantly lower or higher fair value measurement. For example, a change in either direction of actual loss rates would have a directionally opposite change in the calculation of the fair value of unsecured impaired loans.

Note 10 – Investments

Although the Company currently has the intent and the ability to hold the securities in its investment portfolio to maturity, the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management. Pursuant to FASB’s guidance on accounting for debt and equity securities, available for sale securities are carried on the Company’s financial statements at their estimated fair market values, with monthly tax-effected “mark-to-market” adjustments made vis-à-vis accumulated other comprehensive income in shareholders’ equity.

Amortized Cost And Estimated Fair Value

The amortized cost and estimated fair value of investment securities available-for-sale are as follows (dollars in thousands, unaudited):

	September 30, 2014
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value

US Government agencies	$	4,464	$	6	$	(81	)	$	4,389
Mortgage-backed securities		359,954		3,804		(1,644	)		362,114
State and poltical subdivisions		96,199		2,923		(499	)		98,623
Equity securities		1,373		1,189		-			2,562
Total investment securities	$	461,990	$	7,922	$	(2,224	)	$	467,688

	December 31, 2013
	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value

US Government agencies	$	5,395	$	18	$	(109	)	$	5,304
Mortgage-backed securities		320,223		3,269		(2,771	)		320,721
State and political subdivisons		97,361		1,723		(2,521	)		96,563
Equity securities		1,336		1,120		-			2,456
Total investment securities	$	424,315	$	6,130	$	(5,401	)	$	425,044

At September 30, 2014 and December 31, 2013, the Company had 164 securities and 197 securities, respectively, with unrealized losses. Management has evaluated those securities as of the respective dates, and does not believe that any of the associated unrealized losses are other than temporary. Gross unrealized losses on our investment securities as of the indicated dates are disclosed in the table below, categorized by investment type and by the duration of time that loss positions on individual securities have continuously existed (over or under twelve months).

Investment Portfolio - Unrealized Losses
(dollars in thousands, unaudited)	September 30, 2014
	Less than Twelve Months					Over Twelve Months
	Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value

US Government agencies	$	(19	)	$	1,260	$	(62	)	$	1,937
Mortgage-backed securities		(576	)		99,447		(1,068	)		68,444
State and political subdivisions		(10	)		2,451		(489	)		23,571
Other securities		-			-		-			-
Total	$	(605	)	$	103,158	$	(1,619	)	$	93,952

	December 31, 2013
	Less than Twelve Months					Over Twelve Months
	Gross Unrealized Losses			Fair Value		Gross Unrealized Losses			Fair Value

US Government agencies	$	(92	)	$	1,913	$	(17	)	$	1,920
Mortgage-backed securities		(642	)		21,747		(2,129	)		124,317
State and political subdivisions		(461	)		6,799		(2,060	)		38,083
Other securities		-			-		-			-
Total	$	(1,195	)	$	30,459	$	(4,206	)	$	164,320

The table below summarizes the Company’s gross realized gains and losses as well as gross proceeds from the sales of securities, for the periods indicated:

Investment Portfolio - Realized Gains/(Losses)

(dollars in thousands, unaudited)

	Three months ended September 30,				Nine months ended September 30,
	2014		2013		2014			2013

Proceeds from sales of securities available for sale	$	-	$	-	$	8,360		$	723

Gross gains on sale of securities available for sale	$	-	$	-	$	289		$	6
Gross losses on sale of securities available for sale		-		-		(2	)		-
Net gains on sale of securities available for sale	$	-	$	-	$	287		$	6

The amortized cost and estimated fair value of investment securities available-for-sale at September 30, 2014 and December 31, 2013 are shown below, by the remaining time to contractual maturity dates. The expected life of investment securities may not be consistent with contractual maturity dates, since the issuers of the securities could have the right to call or prepay obligations with or without penalties.

Estimated Fair Value of Contractual Maturities
(dollars in thousands, unaudited)	September 30, 2014
	Amortized Cost		Fair Value

Maturing within one year	$	1,204	$	1,212
Maturing after one year through five years		213,652		216,249
Maturing after five years through ten years		76,629		77,761
Maturing after ten years		50,748		51,294

Investment securities not due at a single maturity date:
U.S Government agencies collateralized by mortgage obligations		118,384		118,610
Other securities		1,373		2,562
	$	461,990	$	467,688

	December 31, 2013
	Amortized Cost		Fair Value

Maturing within one year	$	2,294	$	2,316
Maturing after one year through five years		241,396		242,493
Maturing after five years through ten years		59,572		59,402
Maturing after ten years		49,674		47,737

Investment securities not due at a single maturity date:
U.S Government agencies collateralized by mortgage obligations		70,043		70,640
Other securities		1,336		2,456
	$	424,315	$	425,044

At September 30, 2014, the Company’s investment portfolio included securities issued by 268 different government municipalities and agencies located within 27 states with a fair value of $98.6 million. The largest exposure to any single municipality or agency was a $4.5 million (fair value) bond issued for water utility improvements by the Arizona State Water Infrastructure Finance Authority, to be repaid by future water revenue.

The Company’s investments in bonds issued by states, municipalities and political subdivisions are evaluated in accordance with Supervision and Regulation Letter 12-15 (SR 12-15) issued by the Board of Governors of the Federal Reserve System, “Investing in Securities without Reliance on Nationally Recognized Statistical Rating Organization Ratings”, and other regulatory guidance. Credit ratings are considered in our analysis only as a guide to the historical default rate associated with similarly-rated bonds. There have been no significant differences in our internal analyses compared with the ratings assigned by the third party credit rating agencies.

The following table summarizes the amortized cost and fair values of general obligation and revenue bonds in the Company’s investment securities portfolio at the indicated dates, identifying the state in which the issuing municipality or agency operates for our largest geographic concentrations:

Revenue and General Obligation Bonds by Location
dollars in thousands, unaudited	September 30, 2014				December 31, 2013
	Amortized		Fair Market		Amortized		Fair Market
General obligation bonds	Cost		Value		Cost		Value
State of issuance
California	$	20,026	$	21,219	$	20,638	$	21,272
Texas		12,831		12,958		11,340		11,024
Illinois		8,287		8,392		8,965		8,702
Ohio		7,640		7,703		7,659		7,485
Washington		5,981		6,109		5,487		5,340
Arizona		2,077		2,417		2,100		2,050
Other states		19,776		19,930		20,666		20,429
Total General Obligation Bonds		76,618		78,728		76,855		76,302

Revenue bonds
State of issuance
Arizona		4,617		4,508		4,700		4,341
Texas		3,284		3,394		2,762		2,719
California		2,219		2,284		2,519		2,579
Washington		1,168		1,204		1,170		1,211
Ohio		322		335		324		339
Other states		7,971		8,170		6,758		6,742
Total Revenue Bonds		19,581		19,895		18,233		17,931

Certificates of participation (All California)		-		-		2,273		2,330

Total Obligations of States and Political Subdivisions	$	96,199	$	98,623	$	97,361	$	96,563

The revenue bonds in the Company’s investment securities portfolios were issued by government municipalities and agencies to fund public services such as utilities (water, sewer, and power), educational facilities, and general public and economic improvements. The primary sources of revenue for these bonds are delineated in the table below, which shows the amortized cost and fair market values for the largest revenue concentrations as of the indicated dates.

Revenue Bonds by Type
dollars in thousands, unaudited	September 30, 2014				December 31, 2013
	Amortized		Fair Market		Amortized		Fair Market
Revenue bonds	Cost		Value		Cost		Value
Revenue source:
Water	$	8,010	$	8,010	$	7,409	$	7,144
College & University		2,731		2,840		2,203		2,187
Electric & Power		1,882		1,921		1,888		1,895
Sales Tax		1,672		1,715		1,673		1,688
Lease		1,356		1,344		1,155		1,063
Other sources		3,930		4,065		3,905		3,954
Total Revenue Bonds	$	19,581	$	19,895	$	18,233	$	17,931

Note 11 – Credit Quality and Nonperforming Assets

Credit Quality Classifications

The Company monitors the credit quality of loans on a continuous basis using the regulatory and accounting classifications of pass, special mention, substandard and impaired to characterize the associated credit risk. Balances classified as “loss” are immediately charged off. The Company conforms to the following definitions for risk classifications utilized:

Pass: Larger non-homogeneous loans not meeting the risk rating definitions below, and smaller homogeneous loans that are not assessed on an individual basis.

Special mention: Loans which have potential issues that deserve the close attention of management. If left uncorrected, those potential weaknesses could eventually diminish the prospects for full repayment of principal and interest according to the contractual terms of the loan agreement, or could result in deterioration of the Company’s credit position at some future date.

Substandard: Loans that have at least one clear and well-defined weakness which could jeopardize the ultimate recoverability of all principal and interest, such as a borrower displaying a highly leveraged position, unfavorable financial operating results and/or trends, uncertain repayment sources or a deteriorated financial condition.

Impaired: A loan is considered 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. Impaired loans include all nonperforming loans, restructured troubled debt (TDRs), and certain other loans that are still being maintained on accrual status. A TDR may be nonperforming or performing, depending on its accrual status and the demonstrated ability of the borrower to comply with restructured terms (see “Troubled Debt Restructurings” section below for additional information on TDRs).

Credit quality classifications for the Company’s loan balances were as follows, as of the dates indicated:

Credit Quality Classifications

(dollars in thousands, unaudited)

	September 30, 2014
	Pass		Special Mention		Substandard		Impaired		Total
Real Estate:
1-4 family residential construction	$	4,908	$	-	$	-	$	-	$	4,908
Other construction/land		19,050		253		10		4,522		23,835
1-4 family - closed end		100,113		527		597		12,820		114,057
Equity lines		44,832		514		1,244		700		47,290
Multi-family residential		7,245		422		-		-		7,667
Commercial real estate - owner occupied		171,724		20,983		2,797		3,572		199,076
Commercial real estate - non-owner occupied		92,438		3,363		226		12,830		108,857
Farmland		129,553		2,700		77		-		132,330
Total real estate		569,863		28,762		4,951		34,444		638,020

Agricultural		23,902		592		-		127		24,621
Commercial and industrial		99,550		2,379		305		2,925		105,159
Mortgage Warehouse		96,459		-		-		-		96,459
Consumer loans		16,191		266		21		2,938		19,416
Total gross loans and leases	$	805,965	$	31,999	$	5,277	$	40,434	$	883,675

	December 31, 2013
	Pass		Special Mention		Substandard		Impaired		Total
Real Estate:
1-4 family residential construction	$	1,720	$	-	$	-	$	-	$	1,720
Other construction/land		18,243		334		203		6,751		25,531
1-4 family - closed end		67,051		1,305		770		17,898		87,024
Equity lines		51,019		254		1,429		1,021		53,723
Multi-family residential		8,059		426		-		-		8,485
Commercial real estate - owner occupied		158,155		17,033		3,261		7,563		186,012
Commercial real estate - non-owner occupied		89,475		3,630		240		13,495		106,840
Farmland		105,623		1,780		819		282		108,504
Total real estate		499,345		24,762		6,722		47,010		577,839

Agricultural		24,178		532		-		470		25,180
Commercial and industrial		93,224		3,358		1,236		5,444		103,262
Mortgage Warehouse		73,425		-		-		-		73,425
Consumer loans		19,387		478		208		3,463		23,536
Total gross loans and leases	$	709,559	$	29,130	$	8,166	$	56,387	$	803,242

Past Due and Nonperforming Assets

Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, and foreclosed assets, including mobile homes and other real estate owned (OREO). OREO consists of properties acquired by foreclosure or similar means, which the Company is offering or will offer for sale. Nonperforming loans and leases result when reasonable doubt surfaces with regard to the ability of the Company to collect all principal and interest. At that point, we stop accruing interest on the loan or lease in question and reverse any previously-recognized interest to the extent that it is uncollected or associated with interest-reserve loans. Any asset for which principal or interest has been in default for 90 days or more is also placed on non-accrual status even if interest is still being received, unless the asset is both well secured and in the process of collection. An aging of the Company’s loan balances is presented in the following tables, by number of days past due as of the indicated dates:

Loan Portfolio Aging

(dollars in thousands, unaudited)

	September 30, 2014
	30-59 Days Past Due		60-89 Days Past Due		90 Days Or More Past Due⁽¹⁾		Total Past Due		Current		Total Financing Receivables		Non-Accrual Loans⁽²⁾
Real Estate:
1-4 family residential construction	$	-	$	-	$	-	$	-	$	4,908	$	4,908	$	-
Other construction/land		638		-		3,338		3,976		19,859		23,835		3,338
1-4 family - closed end		68		529		8,384		8,981		105,076		114,057		8,446
Equity lines		447		-		-		447		46,843		47,290		385
Multi-family residential		-		-		-		-		7,667		7,667		-
Commercial real estate - owner occupied		139		345		1,143		1,627		197,449		199,076		2,359
Commercial real estate - non-owner occupied		206		-		7,045		7,251		101,606		108,857		7,655
Farmland		109		-		-		109		132,221		132,330		-
Total real estate		1,607		874		19,910		22,391		615,629		638,020		22,183

Agricultural		893		-		127		1,020		23,601		24,621		127
Commercial and industrial		642		103		98		843		104,316		105,159		791
Mortgage Warehouse		-		-		-		-		96,459		96,459		-
Consumer loans		287		4		4		295		19,121		19,416		775
Total gross loans and leases	$	3,429	$	981	$	20,139	$	24,549	$	859,126	$	883,675	$	23,876

⁽¹⁾ As of September 30, 2014 there were no loans over 90 days past due and still acrruing.

⁽²⁾ Included in total financing receivables

	December 31, 2013
	30-59 Days Past Due		60-89 Days Past Due		90 Days Or More Past Due⁽¹⁾		Total Past Due		Current		Total Financing Receivables		Non-Accrual Loans⁽²⁾
Real Estate:
1-4 family residential construction	$	-	$	-	$	-	$	-	$	1,720	$	1,720	$	-
Other construction/land		294		-		116		410		25,121		25,531		5,528
1-4 family - closed end		2,181		300		171		2,652		84,372		87,024		13,168
Equity lines		98		-		288		386		53,337		53,723		778
Multi-family residential		-		-		-		-		8,485		8,485		-
Commercial real estate - owner occupied		1,917		144		2,011		4,072		181,940		186,012		5,516
Commercial real estate - non-owner occupied		-		-		7,667		7,667		99,173		106,840		8,058
Farmland		331		-		-		331		108,173		108,504		282
Total real estate		4,821		444		10,253		15,518		562,321		577,839		33,330

Agricultural		892		327		125		1,344		23,836		25,180		470
Commercial and industrial		1,318		587		1,298		3,203		100,059		103,262		2,622
Mortgage Warehouse		-		-		-		-		73,425		73,425		-
Consumer loans		181		-		-		181		23,355		23,536		992
Total gross loans and leases	$	7,212	$	1,358	$	11,676	$	20,246	$	782,996	$	803,242	$	37,414

⁽¹⁾ As of December 31, 2013 there were no loans over 90 days past due and still accruing.

⁽²⁾ Included in total financing receivables

Troubled Debt Restructurings

A loan that is modified for a borrower who is experiencing financial difficulty is classified as a troubled debt restructuring (TDR), if the modification constitutes a concession. At September 30, 2014, the Company had a total of $32.2 million in TDRs, including $19.2 million in TDRs that were on non-accrual status. Generally, a non-accrual loan that has been modified as a TDR remains on non-accrual status for a period of at least six months to demonstrate the borrower’s ability to comply with the modified terms. However, performance prior to the modification, or significant events that coincide with the modification, could result in a loan’s return to accrual status after a shorter performance period or even at the time of loan modification. TDRs may have the TDR designation removed in the calendar year following the restructuring, if the loan is in compliance with all modified terms and is yielding a market rate of interest. Regardless of the period of time that has elapsed, if the borrower’s ability to meet the revised payment schedule is uncertain then the loan will be kept on non-accrual status. Moreover, a TDR is generally considered to be in default when it appears that the customer will not likely be able to repay all principal and interest pursuant to the terms of the restructured agreement.

The Company may agree to different types of concessions when modifying a loan or lease. The tables below summarize TDRs which were modified during the noted periods, by type of concession:

Troubled Debt Restructurings, by Type of Loan Modification

(dollars in thousands, unaudited)

	Nine months ended September 30, 2014
	Rate Modification		Term Modification		Interest Only Modification		Rate & Term Modification		Rate & Interest Only Modification		Term & Interest Only Modification		Rate, Term & Interest Only Modification		Total

Real estate:
Other construction/land	$	-	$	-	$	-	$	-	$	-	$	-	$	-	$	-
1-4 family - closed-end		-		13		-		-		-		-		-		13
Equity lines		-		548		-		29		-		-		-		577
Commercial real estate - owner occupied		279		123		-		-		-		-		-		402
Total real estate loans		279		684		-		29		-		-		-		992
Commercial and industrial		-		133		-		4		-		30		-		167
Consumer loans		-		9		-		103		-		-		-		112
	$	279	$	826	$	-	$	136	$	-	$	30	$	-	$	1,271

	For the year ended December 31, 2013
	Rate Modification		Term Modification		Interest Only Modification		Rate & Term Modification		Rate & Interest Only Modification		Term & Interest Only Modification		Rate, Term & Interest Only Modification		Total

Real Estate:
Other construction/land	$	-	$	416	$	-	$	-	$	-	$	-	$	-	$	416
1-4 family - closed-end		-		3,338		-		238		-		-		102		3,678
Equity lines		-		-		40		-		-		-		-		40
Commercial real estate - owner occupied		-		-		-		557		-		-		-		557
Total real estate loans		-		3,754		40		795		-		-		102		4,691
Commercial and industrial		-		1,563		-		308		-		-		-		1,871
Consumer loans		-		469		-		-		-		-		92		561
	$	-	$	5,786	$	40	$	1,103	$	-	$	-	$	194	$	7,123

The following tables present, by class, additional details related to loans classified as TDRs during the referenced periods, including the recorded investment in the loan both before and after modification and balances that were modified during the period:

Troubled Debt Restructurings

(dollars in thousands, unaudited)

	For the three months ended September 30, 2014

	Number of Loans	Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment		Reserve Difference⁽¹⁾		Reserve
Real Estate:
Other Construction/Land	-	$	-	$	-	$	-	$	-
1-4 family - closed-end	-		-		-		-		-
Equity Lines	3		227		227		11		20
Commercial RE- owner occupied	-		-		-		-		-
Total Real Estate Loans			227		227		11		20

Commercial and Industrial	-		-		-		-		-
Consumer loans	1		103		103		14		15
		$	330	$	330	$	25	$	35

⁽¹⁾ This represents the change in the ALLL reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowance for loan loss methodology.

	For the nine months ended September 30, 2014

	Number of Loans	Pre- Modification Outstanding Recorded Investment		Post- Modification Outstanding Recorded Investment		Reserve Difference⁽¹⁾		Reserve
Real Estate:
Other Construction/Land	-	$	-	$	-	$	-	$	-
1-4 family - closed-end	1		13		13		-		-
Equity Lines	6		577		577		180		33
Commercial RE- owner occupied	2		402		402		-		136
Total Real Estate Loans			992		992		180		169

Commercial and Industrial	5		167		167		53		57
Consumer loans	4		112		112		15		15
		$	1,271	$	1,271	$	248	$	241

The tables below summarize TDRs that defaulted during the periods noted, and any charge-offs on those TDRs resulting from such default.

Troubled Debt Restructurings

(dollars in thousands, unaudited)

	Subsequent default three months ended September 30, 2014

	Number of Loans	Recorded Investment		Charge-Offs
Real Estate:
Other Construction/Land	-	$	-	$	-
1-4 family - closed-end	-		-		-
Commercial real estate- owner occupied	1		715		-
Total Real Estate Loans			715		-
Commercial and Industrial	-		-		-
Consumer Loans	-		-		-
		$	715	$	-

	Subsequent default nine months ended September 30, 2014

	Number of Loans	Recorded Investment		Charge-Offs

Real Estate:
Other Construction/Land	3	$	1,546	$	-
1-4 family - closed-end	2		8,305		-
Commercial real estate- owner occupied	2		937		31
Total Real Estate Loans			10,788		31
Commercial and Industrial	1		127		-
Consumer Loans	2		133		58
		$	11,048	$	89

Note 12 – Allowance for Loan and Lease Losses

The Company’s allowance for loan and lease losses, a contra-asset, is established through a provision for loan and lease losses. The allowance is maintained at a level that is considered adequate to absorb probable losses on certain specifically identified loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when cash payments are received subsequent to the charge off. We employ a systematic methodology, consistent with FASB guidelines on loss contingencies and impaired loans, for determining the appropriate level of the allowance for loan and lease losses and adjusting it at least quarterly. Pursuant to that methodology, impaired loans and leases are individually analyzed and a criticized asset action plan is completed specifying the financial status of the borrower and, if applicable, the characteristics and condition of collateral and any associated liquidation plan. A specific loss allowance is created for each impaired loan, if necessary.

The following tables disclose the unpaid principal balance, recorded investment, average recorded investment, and interest income recognized for impaired loans on our books as of the dates indicated. Balances are shown by loan type, and are further broken out by those that required an allowance and those that did not, with the associated allowance disclosed for those that required such. Included in the valuation allowance for impaired loans shown in the tables below are specific reserves allocated to TDRs, totaling $3.333 million at September 30, 2014 and $3.321 million at December 31, 2013.

Impaired Loans	September 30, 2014
(dollars in thousands, unaudited)	Unpaid Principal Balance⁽¹⁾		Recorded Investment⁽²⁾		Related Allowance		Average Recorded Investment		Interest Income Recognized⁽³⁾
With an allowance recorded
Real Estate:
Other construction/land	$	4,513	$	4,513	$	578	$	5,271	$	69
1-4 Family - closed-end		12,820		12,820		1,111		14,000		201
Equity lines		406		406		37		491		11
Commercial real estate- owner occupied		2,856		2,746		1,416		3,068		42
Commercial real estate- non-owner occupied		3,700		3,700		741		3,771		198
Farmland		-		-		-		-		-
Total real estate		24,295		24,185		3,883		26,601		521
Agriculture		127		127		3		335		-
Commercial and industrial		2,901		2,888		873		2,958		94
Consumer loans		2,854		2,843		422		3,104		116
		30,177		30,043		5,181		32,998		731
With no related allowance recorded
Real estate:
Other construction/land		9		9		-		18		-
1-4 family - closed-end		-		-		-		-		1
Equity lines		297		294		-		297		-
Commercial real estate- owner occupied		1,855		826		-		1,932		-
Commercial real estate- non-owner occupied		9,278		9,130		-		9,844		88
Farmland		-		-		-		-		-
Total real estate		11,439		10,259		-		12,091		89
Agriculture		-		-		-		-		-
Commercial and industrial		56		37		-		81		-
Consumer loans		257		95		-		322		-
		11,752		10,391		-		12,494		89
Total	$	41,929	$	40,434	$	5,181	$	45,492	$	820

⁽¹⁾Contractual principal balance due from customer.

⁽²⁾Principal balance on Company's books, less any direct charge offs.

⁽³⁾Interest income is recognized on performing balances on a regular accrual basis.

	December 31, 2013
	Unpaid Principal Balance⁽¹⁾		Recorded Investment⁽²⁾		Related Allowance		Average Recorded Investment		Interest Income Recognized⁽³⁾
With an allowance recorded
Real estate:
1-4 family residential construction	$	-	$	-	$	-	$	-	$	-
Other construction/land		2,972		2,972		502		3,000		98
1-4 family - closed-end		13,522		13,522		1,324		13,630		260
Equity lines		528		528		123		530		13
Commercial real estate- owner occupied		2,047		2,047		217		2,069		135
Commercial real estate- non-owner occupied		3,715		3,715		701		3,813		238
Farmland		-		-		-		-		-
Total real estate		22,784		22,784		2,867		23,042		744
Agriculture		125		125		126		131		-
Commercial and industrial		4,580		4,345		1,925		4,496		131
Consumer loans		3,411		3,411		431		3,591		172
		30,900		30,665		5,349		31,260		1,047
With no related allowance recorded
Real estate:
1-4 family residential construction		-		-		-		-		-
Other construction/land		4,176		3,779		-		3,885		-
1-4 family - closed-end		4,655		4,376		-		4,687		1
Equity lines		565		493		-		493		-
Commercial real estate- owner occupied		7,436		5,516		-		5,568		-
Commercial real estate- non-owner occupied		10,077		9,780		-		9,820		115
Farmland		282		282		-		290		-
Total real estate		27,191		24,226		-		24,743		116
Agriculture		345		345		-		837		-
Commercial and industrial		1,249		1,099		-		1,607		57
Consumer loans		241		52		-		77		-
		29,026		25,722		-		27,264		173
Total	$	59,926	$	56,387	$	5,349	$	58,524	$	1,220

⁽¹⁾Contractual principal balance due from customer.

⁽²⁾Principal balance on Company's books, less any direct charge offs.

⁽³⁾Interest income is recognized on performing balances on a regular accrual basis.

The specific loss allowance for an impaired loan generally represents the difference between the book value of the loan and either the fair value of underlying collateral less estimated disposition costs, or the loan’s net present value as determined by a discounted cash flow analysis. The discounted cash flow approach is typically used to measure impairment on loans for which it is anticipated that repayment will be provided from cash flows other than those generated solely by the disposition or operation of underlying collateral. However, historical loss rates may be used to determine a specific loss allowance if they indicate a higher potential reserve need than the discounted cash flow analysis. Any change in impairment attributable to the passage of time is accommodated by adjusting the loss allowance accordingly.

For loans where repayment is expected to be provided by the disposition or operation of the underlying collateral, impairment is measured using the fair value of the collateral. If the collateral value, net of the expected costs of disposition where applicable, is less than the loan balance, then a specific loss reserve is established for the shortfall in collateral coverage. If the discounted collateral value is greater than or equal to the loan balance, no specific loss reserve is required. At the time a collateral-dependent loan is designated as nonperforming, a new appraisal is ordered and typically received within 30 to 60 days if a recent appraisal is not already available. We generally use external appraisals to determine the fair value of the underlying collateral for nonperforming real estate loans, although the Company’s licensed staff appraisers may update older appraisals based on current market conditions and property value trends. Until an updated appraisal is received, the Company uses the existing appraisal to determine the amount of the specific loss allowance that may be required, and adjusts the specific loss allowance, as necessary, once a new appraisal is received. Updated appraisals are generally ordered at least annually for collateral-dependent loans that remain impaired. Current appraisals were available for 84% of the Company’s impaired real estate loan balances at September 30, 2014. Furthermore, the Company analyzes collateral-dependent loans on at least a quarterly basis, to determine if any portion of the recorded investment in such loans can be identified as uncollectible and would therefore constitute a confirmed loss. All amounts deemed to be uncollectible are promptly charged off against the Company’s allowance for loan and lease losses, with the loan then carried at the fair value of the collateral, as appraised, less estimated costs of disposition if applicable. Once a charge-off or write-down is recorded, it will not be restored to the loan balance on the Company’s accounting books.

Our methodology also provides that a “general” allowance be established for probable incurred losses inherent in loans and leases that are not impaired. Unimpaired loan balances are segregated by credit quality, and are then evaluated in pools with common characteristics. At the present time, pools are based on the same segmentation of loan types presented in our regulatory filings. While this methodology utilizes historical loss data and other measurable information, the classification of loans and the establishment of the allowance for loan and lease losses are both to some extent based on management’s judgment and experience. Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan and lease losses that management believes is appropriate at each reporting date. Quantitative information includes our historical loss experience, delinquency and charge-off trends, and current collateral values. Qualitative factors include the general economic environment in our markets and, in particular, the condition of the agricultural industry and other key industries in our market areas. Lending policies and procedures (including underwriting standards), the experience and abilities of lending staff, the quality of loan review, credit concentrations (by geography, loan type, industry and collateral type), the rate of loan portfolio growth, and changes in legal or regulatory requirements are additional factors that are considered. The total general reserve established for probable incurred losses on unimpaired loans was $5.831 million at September 30, 2014.

During the three months ended September 30, 2014, changes to the methodology used to determine our allowance for loan and lease losses include extending the historical loan loss look-back period from 12 months to 24 months, with more recent periods given higher weighting, and adjusting our qualitative factors accordingly. The potential impact of drought conditions in our markets was also given greater consideration in qualitative factors. As we add new products and expand our geographic coverage, and as the economic environment changes, we expect to continue to enhance our methodology to keep pace with the size and complexity of the loan and lease portfolio and respond to pressures created by external forces. We engage outside firms on a regular basis to assess our methodology and perform independent credit reviews of our loan and lease portfolio. In addition, the Company’s external auditors, the FDIC, and the California DBO review the allowance for loan and lease losses as an integral part of their audit and examination processes. Management believes that the current methodology is appropriate given our size and level of complexity.

The tables that follow detail the activity in the allowance for loan and lease losses for the periods noted:

Allowance for Credit Losses and Recorded Investment in Financing Receivables

(dollars in thousands, unaudited)

	For the three months ended September 30, 2014

	Real Estate			Agricultural			Commercial and Industrial			Consumer			Unallocated			Total

Allowance for credit losses:
Beginning Balance	$	7,278		$	1,353		$	1,516		$	1,463		$	24		$	11,634
Charge-offs		(1,053	)		-			(170	)		(424	)		-			(1,647	)
Recoveries		291			1			538			195			-			1,025
Provision		247			(539	)		26			288			(22	)		-

Ending Balance	$	6,763		$	815		$	1,910		$	1,522		$	2		$	11,012

	For the nine months ended September 30, 2014

	Real Estate			Agricultural			Commercial and Industrial			Consumer			Unallocated			Total

Allowance for credit losses:
Beginning Balance	$	5,544		$	978		$	3,787		$	1,117		$	251		$	11,677
Charge-offs		(1,485	)		(124	)		(583	)		(1,410	)		-			(3,602	)
Recoveries		1,490			4			635			458			-			2,587
Provision		1,214			(43	)		(1,929	)		1,357			(249	)		350

Ending Balance	$	6,763		$	815		$	1,910		$	1,522		$	2		$	11,012

Reserves:
Specific	$	3,883		$	3		$	873		$	422		$	-		$	5,181
General		2,880			812			1,037			1,100		$	2			5,831

Ending Balance	$	6,763		$	815		$	1,910		$	1,522		$	2		$	11,012

Loans evaluated for impairment:
Individually	$	34,444		$	127		$	2,925		$	2,938		$	-		$	40,434
Collectively		603,576			24,494			198,693			16,478			-			843,241

Ending Balance	$	638,020		$	24,621		$	201,618		$	19,416		$	-		$	883,675

	For the Year Ended December 31, 2013

	Real Estate			Agricultural			Commercial and Industrial			Consumer			Unallocated		Total

Allowance for credit losses:
Beginning Balance	$	8,034		$	258		$	3,467		$	2,114		$	-	$	13,873
Charge-offs		(4,205	)		(473	)		(1,668	)		(1,917	)		-		(8,263	)
Recoveries		618			-			802			297			-		1,717
Provision		1,097			1,193			1,186			623			251		4,350

Ending balance	$	5,544		$	978		$	3,787		$	1,117		$	251	$	11,677

Reserves:
Specific	$	2,867		$	126		$	1,925		$	431				$	5,349
General		2,677			852			1,862			686			251		6,328

Ending balance	$	5,544		$	978		$	3,787		$	1,117		$	251	$	11,677

Loans evaluated for impairment:
Individually	$	47,010		$	470		$	5,444		$	3,463		$	-	$	56,387
Collectively		530,829			24,710			171,243			20,073			-		746,855

Ending balance	$	577,839		$	25,180		$	176,687		$	23,536		$	-	$	803,242

PART I - FINANCIAL INFORMATION

ITEM 2

MANAGEMENT’S DISCUSSION AND

ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This Form 10-Q includes forward-looking statements that involve inherent risks and uncertainties. Words such as “expects”, “anticipates”, “believes”, “projects”, and “estimates” or variations of such words and similar expressions are intended to identify forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.

A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations, and should be considered when evaluating the Company’s potential future financial performance. They include, but are not limited to, unfavorable economic conditions in the Company’s service areas; risks associated with fluctuations in interest rates; liquidity risks; increases in nonperforming assets and credit losses that could occur, particularly in times of weak economic conditions or rising interest rates; reductions in the market value of available-for-sale securities that could result if interest rates increase substantially or an issuer has real or perceived financial difficulties; the Company’s ability to attract and retain skilled employees; the Company’s ability to successfully deploy new technology; the success of acquisitions or branch expansion; and risks associated with the multitude of current and prospective laws and regulations to which the Company is and will be subject.

CRITICAL ACCOUNTING POLICIES

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States. The financial information and disclosures contained within those statements are significantly impacted by management’s estimates and judgments, which are based on historical experience and incorporate assumptions that are believed to be reasonable under current circumstances. Actual results may differ from estimates under divergent conditions.

Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations. In management’s opinion, the Company’s critical accounting policies deal with the following areas: the establishment of the Company’s allowance for loan and lease losses, as explained in detail in Note 12 to the consolidated financial statements and the “Provision for Loan and Lease Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; the valuation of impaired loans and foreclosed assets, which is discussed in Note 11 to the consolidated financial statements and in the “Nonperforming Assets” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; income taxes, especially with regard to the ability of the Company to recover deferred tax assets, as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; and goodwill, which is evaluated annually for impairment based on the fair value of the Company as discussed in the “Other Assets” section of this discussion and analysis. Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate the most recent expectations with regard to those areas.

OVERVIEW OF THE RESULTS OF OPERATIONS

AND FINANCIAL CONDITION

results of operations Summary

Third Quarter 2014 compared to Third Quarter 2013

Net income for the quarter ended September 30, 2014 was $3.551 million, representing an increase of $184,000, or 5%, relative to net income of $3.367 million for the quarter ended September 30, 2013. Basic and diluted earnings per share for the third quarter of 2014 were $0.25, compared to $0.24 basic earnings per share and $0.23 diluted earnings per share for the third quarter of 2013. The Company’s annualized return on average equity was 7.51% and annualized return on average assets was 0.95% for the quarter ended September 30, 2014, compared to 7.60% and 0.97%, respectively, for the quarter ended September 30, 2013. The primary drivers behind the quarter over quarter variance in net income are as follows:

Net interest income increased $1.291 million, or 11%, due primarily to a $123 million increase in average interest-earning assets and a higher level of non-recurring interest income.

There was no loan loss provision recorded in the third quarter of 2014, relative to $800,000 in the third quarter of 2013.

Total non-interest income was down $534,000 for the quarterly comparison, representing a drop of 12% due to lower income on overdrafts and returned items, reduced income on bank-owned life insurance (BOLI) associated with deferred compensation plans, declining fees on merchant accounts and higher expense accruals associated with our low-income housing tax credit investments.

Total non-interest expense increased $260,000, or 2%, primarily due to costs associated with our new core banking system that was implemented in February 2014, residual costs related to our recent rebranding efforts, non-recurring acquisition costs incurred in the third quarter of 2014, loan sale expenses and higher occupancy expense, partially offset by lower deferred compensation accruals and a reduction in net expenses associated with foreclosed assets.

The Company’s provision for income taxes was 33% of pre-tax income for the third quarter of 2014 as compared to 16% for the third quarter of 2013, with the increase resulting from a higher level of taxable income relative to the Company’s available tax credits as well as an adjustment of $310,000 to true-up tax accruals subsequent to the filing of our prior-year income tax returns in September 2014.

First Nine Months 2014 compared to First Nine Months 2013

Net income for the first nine months of 2014 was $11.586 million, representing an increase of $2.087 million, or 22%, relative to net income of $9.499 million for the first nine months of 2013. Basic and diluted earnings per share for the first nine months of 2014 were $0.82 and $0.81, respectively, compared to $0.67 basic and diluted earnings per share for the first nine months of 2013. The Company’s annualized return on average equity was 8.33% and annualized return on average assets was 1.06% for the nine months ended September 30, 2014, compared to a return on equity of 7.23% and return on assets of 0.91% for the nine months ended September 30, 2013. The primary drivers behind the variance in year-to-date net income are as follows:

The single largest impact on the comparative year-to-date results came from a reduction of $2.500 million, or 88%, in the loan loss provision.

Net interest income increased $2.337 million, or 6%, due to an $80 million increase in average interest-earning assets and a higher level of non-recurring interest income.

Total non-interest income declined by $946,000, or 8%, for the comparative year-to-date periods due in large part to a drop in service charges on deposits, lower BOLI income, lower merchant fees and higher expense accruals associated with our tax credit investments, partially offset by an increase in gains realized on the sale of investment securities.

Total non-interest expense fell by $541,000, or 2%, as higher marketing, data processing, deposit, and non-recurring acquisition and loan sale costs were more than offset by a reduction of $2.013 million in net costs associated with foreclosed assets, a drop in deferred compensation expense accruals, lower telecommunications costs, and a reduction in legal and accounting costs.

The Company’s provision for income taxes was 28% of pre-tax income for the first nine months of 2014 relative to 19% for the first nine months of 2013, with the rate impacted by the same factors outlined in the quarterly comparison.

Financial Condition Summary

September 30, 2014 relative to December 31, 2013

The most significant characteristics of, and changes in, the Company’s balance sheet during the nine months ended September 30, 2014 are outlined below:

The Company’s assets totaled $1.489 billion at September 30, 2014, an increase of $79 million, or 6%, relative to total assets of $1.410 billion at December 31, 2013 due to growth in loans and investments net of reductions in foreclosed assets and balances due from banks.

Gross loans increased by $80 million, or 10%, due to the purchase of $33 million in residential mortgage loans in the first quarter of 2014 and strong organic growth in agricultural real estate loans, mortgage warehouse loans and commercial real estate loans.

Total nonperforming assets were reduced by $17 million, or 37%, during the first nine months of 2014, with the bulk sale of a total of $10 million in nonperforming loans in the second and third quarters contributing to the reduction. The Company’s ratio of nonperforming assets to loans plus foreclosed assets was 3.22% at September 30, 2014, compared to 5.62% at December 31, 2013.

Cash and due from banks was down $38 million, or 49%, as we deployed excess liquidity into longer-term bonds, and investment securities thus increased by $43 million, or 10%.

Deposits reflect growth of $49 million, or 4%, for the nine months ended September 30, 2014, but experienced a decline during the third quarter due to seasonal deposit runoff. Core non-maturity deposits were up $67 million, or 8%, but growth in non-maturity deposits was partially offset by the runoff of $13 million in customer time deposits and a $5 million reduction in wholesale brokered deposits.

Total capital increased by $4.6 million, or 3%, to $186 million at September 30, 2014, due primarily to the addition of net income to retained earnings, net of the impact of cash dividends paid and the Company’s share repurchases. While still robust, our consolidated total risk-based capital ratio declined to 20.06% at September 30, 2014 from 21.67% at year-end 2013 due to growth in risk-adjusted assets. Our tier one risk-based capital ratio was 18.94% and our tier one leverage ratio was 13.61% at September 30, 2014.

EARNINGS PERFORMANCE

The Company earns income from two primary sources. The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities. The second is non-interest income, which consists mainly of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance. The majority of the Company’s non-interest expense is comprised of operating costs that relate to providing a full range of banking services to our customers.

Net interest income AND NET INTEREST MARGIN

Net interest income increased by $1.291 million, or 11%, for the third quarter of 2014 relative to the third quarter of 2013, and by $2.337 million, or 6%, for the first nine months of 2014 compared to the first nine months of 2013. The level of net interest income recognized in any given period depends on a combination of factors including the average volume and yield for interest-earning assets, the average volume and cost of interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities. Net interest income is also impacted by the reversal of interest for loans placed on non-accrual status during the reporting period, and the recovery of interest on loans that had been on non-accrual and were paid off, sold or returned to accrual status.

The following tables show average balances for significant balance sheet categories and the amount of interest income or interest expense associated with each applicable category for the noted periods. The tables also display the calculated yields on each major component of the Company’s investment and loan portfolios, the average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the noted periods.

Average Balances and Rates	For the three months ended							For the three months ended
(dollars in thousands, except per share data)	September 30, 2014							September 30, 2013
Assets	Average Balance ⁽¹⁾		Income/ Expense		Average Rate/Yield ⁽²⁾⁽³⁾			Average Balance ⁽¹⁾		Income/ Expense		Average Rate/Yield ⁽²⁾⁽³⁾
Investments:
Federal funds sold/due from time	$	6,149	$	4		0.25	%	$	44,791	$	28		0.24	%
Taxable		361,918		1,935		2.09	%		299,278		1,132		1.48	%
Non-taxable		97,819		729		4.42	%		87,902		699		4.71	%
Equity		2,523		73		11.32	%		2,360		-		-
Total investments		468,409		2,741		2.60	%		434,331		1,859		2.00	%

Loans and Leases:⁽⁴⁾
Real estate		641,766		8,403		5.19	%		564,174		7,898		5.55	%
Agricultural		25,926		244		3.73	%		27,086		279		4.09	%
Commercial		98,552		1,078		4.34	%		95,121		1,183		4.93	%
Consumer		20,297		501		9.79	%		24,607		519		8.37	%
Mortgage Warehouse Lines		95,323		966		4.02	%		82,198		1,015		4.90	%
Direct financing leases		2,266		31		5.43	%		2,773		38		5.44	%
Other		305		14		18.21	%		7		-		-
Total loans and leases		884,435		11,237		5.04	%		795,966		10,932		5.45	%
Total interest earning assets⁽⁵⁾		1,352,844		13,978		4.21	%		1,230,297		12,791		4.24	%
Other earning assets		6,122							5,932
Non-earning assets		126,454							140,017
Total assets	$	1,485,420						$	1,376,246

Liabilities and shareholders' equity
Interest bearing deposits:
Demand deposits	$	109,825	$	76		0.27	%	$	84,181	$	74		0.35	%
NOW		251,825		84		0.13	%		193,289		88		0.18	%
Savings accounts		153,670		44		0.11	%		135,255		73		0.21	%
Money market		74,014		16		0.09	%		67,859		20		0.12	%
CDAR's		12,817		8		0.25	%		13,812		10		0.29	%
Certificates of deposit<$100,000		75,713		80		0.42	%		85,406		102		0.47	%
Certificates of deposit>$100,000		199,666		172		0.34	%		210,273		201		0.38	%
Brokered deposits		6,337		23		1.44	%		11,793		38		1.28	%
Total interest bearing deposits		883,867		503		0.23	%		801,868		606		0.30	%
Borrowed Funds:
Federal funds purchased		1		-		-			4		-		-
Repurchase agreements		5,289		5		0.38	%		3,255		4		0.49	%
Short term borrowings		6,413		1		0.06	%		-		-		-
Long term borrowings		-		-		-			-		-		-
TRUPS		30,928		177		2.27	%		30,928		180		2.31	%
Total borrowed funds		42,631		183		1.70	%		34,187		184		2.14	%
Total interest bearing liabilities		926,498		686		0.29	%		836,055		790		0.37	%
Demand deposits - non-interest bearing		355,994							353,110
Other liabilities		15,320							11,375
Shareholders' equity		187,608							175,706
Total liabilities and shareholders' equity	$	1,485,420						$	1,376,246

Interest income/interest earning assets						4.21	%						4.24	%
Interest expense/interest earning assets						0.20	%						0.25	%
Net interest income and margin⁽⁶⁾			$	13,292		4.01	%			$	12,001		3.99	%

⁽¹⁾

Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.

⁽²⁾

Yields and net interest margin have been computed on a tax equivalent basis utilizing a 34% effective tax rate.

⁽³⁾

Annualized

⁽⁴⁾

Loan costs have been included in the calculation of interest income. Loan costs were approximately $259 thousand and $52 thousand for the quarters ended September 30, 2014 and 2013. Loans are gross of the allowance for possible loan losses.

⁽⁵⁾

Non-accrual loans have been included in total loans for purposes of total earning assets.

⁽⁶⁾

Net interest margin represents net interest income as a percentage of average interest-earning assets.

Average Balances and Rates	For the nine months ended							For the nine months ended
(dollars in thousands, except per share data)	September 30, 2014							September 30, 2013
Assets	Average Balance ⁽¹⁾		Income/ Expense		Average Rate/Yield ⁽²⁾⁽³⁾			Average Balance ⁽¹⁾		Income/ Expense		Average Rate/Yield ⁽²⁾⁽³⁾
Investments:
Federal funds sold/Due from time	$	28,239	$	55		0.26	%	$	38,720	$	72		0.25	%
Taxable		351,507		5,636		2.11	%		308,138		3,311		1.42	%
Non-taxable		97,193		2,203		4.53	%		83,719		1,990		4.75	%
Equity		2,526		73		3.81	%		2,149		17		1.04	%
Total Investments		479,465		7,967		2.50	%		432,726		5,390		1.95	%

Loans and Leases:⁽⁴⁾
Real Estate		618,600		24,626		5.32	%		556,369		23,221		5.58	%
Agricultural		24,798		737		3.97	%		25,047		760		4.06	%
Commercial		97,493		3,253		4.46	%		97,294		3,692		5.07	%
Consumer		21,747		1,469		9.03	%		25,840		1,616		8.36	%
Mortgage Warehouse Lines		77,343		2,429		4.20	%		101,772		3,796		4.99	%
Direct Financing Leases		2,367		96		5.42	%		3,067		122		5.32	%
Other		293		34		15.51	%		9		-		-
Total Loans and Leases		842,641		32,644		5.18	%		809,398		33,207		5.49	%
Total Interest Earning Assets⁽⁵⁾		1,322,106		40,611		4.22	%		1,242,124		38,597		4.26	%
Other Earning Assets		6,043							6,157
Non-Earning Assets		129,603							140,929
Total Assets	$	1,457,752						$	1,389,210

Liabilities and Shareholders' Equity
Interest Bearing Deposits:
Demand Deposits	$	104,481	$	209		0.27	%	$	85,035	$	225		0.35	%
NOW		239,614		253		0.14	%		195,016		281		0.19	%
Savings Accounts		151,362		195		0.17	%		129,911		209		0.22	%
Money Market		73,035		57		0.10	%		71,359		74		0.14	%
CDAR's		12,999		24		0.25	%		13,933		30		0.29	%
Certificates of Deposit<$100,000		77,797		258		0.44	%		92,362		326		0.47	%
Certificates of Deposit>$100,000		201,697		546		0.36	%		212,597		630		0.40	%
Brokered Deposits		6,256		72		1.54	%		11,648		119		1.37	%
Total Interest Bearing Deposits		867,241		1,614		0.25	%		811,861		1,894		0.31	%
Borrowed Funds:
Federal Funds Purchased		15		-		-			2		-		-
Repurchase Agreements		5,753		14		0.33	%		2,314		10		0.58	%
Short Term Borrowings		2,408		2		0.11	%		4,675		6		0.17	%
Long Term Borrowings		-		-		-			1,392		33		3.17	%
TRUPS		30,928		526		2.27	%		30,928		536		2.32	%
Total Borrowed Funds		39,104		542		1.85	%		39,311		585		1.99	%
Total Interest Bearing Liabilities		906,345		2,156		0.32	%		851,172		2,479		0.39	%
Demand deposits- non interest bearing		347,942							345,939
Other liabilities		17,415							16,394
Shareholders' equity		186,050							175,705
Total liabilities and shareholders' equity	$	1,457,752						$	1,389,210

Interest Income/Interest Earning Assets						4.22	%						4.26	%
Interest Expense/Interest Earning Assets						0.22	%						0.26	%
Net Interest Income and Margin⁽⁶⁾			$	38,455		4.00	%			$	36,118		4.00	%

⁽¹⁾

Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.

⁽²⁾

Yields and net interest margin have been computed on a tax equivalent basis utilizing a 34% effective tax rate.

⁽³⁾

Annualized

⁽⁴⁾

Loan costs have been included in the calculation of interest income. Loan costs were approximately $608 thousand and $84 thousand for the nine months ended September 30, 2014 and 2013. Loans are gross of the allowance for possible loan losses.

⁽⁵⁾

Non-accrual loans have been included in total loans for purposes of total earning assets.

⁽⁶⁾

Net interest margin represents net interest income as a percentage of average interest-earning assets.

The Volume and Rate Variances table below sets forth the dollar difference in interest earned or paid for each major category of interest-earning assets and interest-bearing liabilities for the noted periods, and the amount of such change attributable to fluctuations in average balances (volume) or differences in average interest rates. Volume variances are equal to the increase or decrease in average balance multiplied by prior period rates, and rate variances are equal to the increase or decrease in rate times prior period average balances. Variances attributable to both rate and volume changes, calculated by multiplying the change in rate by the change in average balance, have been allocated to the rate variance.

Volume & Rate Variances	Three months ended September 30,									Nine months ended September 30,
(dollars in thousands)	2014 over 2013									2014 over 2013
	Increase(decrease) due to									Increase(decrease) due to
Assets:	Volume			Rate			Net			Volume			Rate			Net
Investments:
Federal funds sold / Due from time	$	(24	)	$	-		$	(24	)	$	(19	)	$	2		$	(17	)
Taxable		237			566			803			466			1,859			2,325
Non-taxable⁽¹⁾		79			(49	)		30			320			(107	)		213
Equity		-			73			73			3			53			56
Total Investments		292			590			882			770			1,807			2,577
Loans and Leases:
Real Estate		1,086			(581	)		505			2,597			(1,192	)		1,405
Agricultural		(12	)		(23	)		(35	)		(8	)		(15	)		(23	)
Commercial		43			(148	)		(105	)		8			(447	)		(439	)
Consumer		(91	)		73			(18	)		(256	)		109			(147	)
Mortgage Warehouse		162			(211	)		(49	)		(911	)		(456	)		(1,367	)
Direct Financing Leases		(7	)		-			(7	)		(28	)		2			(26	)
Other		-			14			14			-			34			34
Total Loans and Leases		1,181			(876	)		305			1,402			(1,965	)		(563	)
Total Interest Earning Assets	$	1,473		$	(286	)	$	1,187		$	2,172		$	(158	)	$	2,014
Liabilities
Interest Bearing Deposits:
Demand Deposits	$	23		$	(21	)	$	2		$	51		$	(67	)	$	(16	)
NOW		27			(31	)		(4	)		64			(92	)		(28	)
Savings Accounts		10			(39	)		(29	)		35			(49	)		(14	)
Money Market		2			(6	)		(4	)		2			(19	)		(17	)
CDAR's		(1	)		(1	)		(2	)		(2	)		(4	)		(6	)
Certificates of Deposit < $100,000		(12	)		(10	)		(22	)		(51	)		(17	)		(68	)
Certificates of Deposit > $100,000		(10	)		(19	)		(29	)		(32	)		(52	)		(84	)
Brokered Deposits		(18	)		3			(15	)		(55	)		8			(47	)
Total Interest Bearing Deposits		21			(124	)		(103	)		12			(292	)		(280	)
Borrowed Funds:
Federal Funds Purchased		-			-			-			-			-			-
Repurchase Agreements		2			(1	)		1			15			(11	)		4
Short Term Borrowings		-			1			1			(3	)		(1	)		(4	)
Long Term Borrowings		-			-			-			(33	)		-			(33	)
TRUPS		-			(3	)		(3	)		-			(10	)		(10	)
Total Borrowed Funds		2			(3	)		(1	)		(21	)		(22	)		(43	)
Total Interest Bearing Liabilities		23			(127	)		(104	)		(9	)		(314	)		(323	)
Net Interest Margin/Income	$	1,450		$	(159	)	$	1,291		$	2,181		$	156		$	2,337

⁽¹⁾ Yields on tax exempt income have not been computed on a tax equivalent basis.

The volume variance calculated for the third quarter of 2014 relative to the third quarter of 2013 was a favorable $1.450 million, due primarily to a $123 million increase in the average balance of interest-earning assets. The volume variance for the comparative quarters was enhanced by migration from time deposits into lower-cost non-maturity deposits.

The impact of interest rate changes resulted in an unfavorable rate variance of $159,000 in net interest income for the comparative quarters. Our weighted average yield on interest-earning assets fell 3 basis points due to a 41 basis point decline in loan yields stemming from continued competition for quality loans, partially offset by a higher investment portfolio yield. Investment yields were up due to favorable trends in prepayment rates on mortgage-backed securities, which impacted the amortization of premiums and accretion of discounts. Primarily because of a drop in customer deposit rates, the weighted average cost of interest-bearing liabilities was 8 basis points lower for the quarter. Even though this was more than double the decline in our yield on earning assets, the quarter-over-quarter rate variance was still unfavorable due to the volume differential between interest-earning assets and interest-bearing liabilities. That differential averaged $394 million for the third quarter of 2013, the base period for the rate variance calculation, thus the decrease in our earning asset yield was applied to a much higher balance than the rate decrease for interest-bearing liabilities and had a greater impact on net interest income. Partially alleviating the negative pressure on our rate variance was non-recurring interest income such as interest recovered on non-accrual loans resolved during the quarter and prepayment penalties (net of interest reversals for loans placed on non-accrual status), which totaled $135,000 in the third quarter of 2014 relative to $39,000 in the third quarter of 2013.

The Company’s net interest margin, which is tax-equivalent net interest income as a percentage of average interest-earning assets, is affected by the same factors discussed above relative to rate and volume variances. Our net interest margin was 4.01% in the third quarter of 2014, an increase of two basis points relative to the third quarter of 2013. The principal developments favorably impacting our net interest margin in the third quarter of 2014 include a higher level of non-recurring interest income, an increase in the yield on investments, lower deposit rates, and a shift from higher-cost time deposits into lower-cost non-maturity deposits. Partially offsetting those favorable factors were competitive pressures on loan yields.

For the comparative year-to-date periods ended September 30, 2014 and 2013, the favorable variance in net interest income attributable to volume changes was $2.181 million, and there was also a small favorable rate variance of $156,000. The year-to-date volume variance was primarily due to an $80 million increase in average interest-earning assets, which was enhanced by relatively strong growth in the average balances of low-cost customer deposits and equity. The volume variance was negatively impacted by a large increase in the average balance of lower yielding investments, which were up 11% relative to an increase of only 4% in average loan balances. The favorable rate variance for the year-to-date period is the result of a four basis point drop in the yield on average interest-earning assets relative to a seven basis point decline in the cost of interest-bearing liabilities, partially offset by the impact of the volume differential between interest-earning assets and interest-bearing liabilities. As with the quarter, non-recurring interest income favorably impacted the rate variance for the year-to-date comparison. Net interest recoveries and prepayment penalties totaled $423,000 for the first nine months of 2014, relative to only $161,000 in the first nine months of 2013. The Company’s net interest margin for the first nine months of 2014 was 4.00%, the same as our net interest margin for the first nine months of 2013.

Provision for loan and LEASE losses

Credit risk is inherent in the business of making loans. The Company sets aside an allowance for loan and lease losses, a contra-asset account, through periodic charges to earnings which are reflected in the income statement as the provision for loan and lease losses. The Company was not required to record a loan loss provision for the third quarter of 2014 due to continued improvement in credit quality, but the loan loss provision was $800,000 in the third quarter of 2013. The loan loss provision was $350,000 for the first nine months of 2014, representing a reduction of $2.500 million, or 88%, relative to the same period in 2013. Our loan loss provision in 2014 has been utilized primarily to replenish reserves subsequent to charge-offs.

The Company’s loan loss provision has been sufficient to maintain our allowance for loan and lease losses at a level that, in management’s judgment, is adequate to absorb probable loan losses related to specifically-identified impaired loans as well as probable incurred losses in the remaining loan portfolio. Specifically identifiable and quantifiable loan losses are immediately charged off against the allowance. We had $622,000 in net loans charged off in the third quarter of 2014 relative to $1.156 million in the third quarter of 2013, for a reduction of $534,000, or 46%. There were $1.015 million in net loan charge-offs in the first nine months of 2014 relative to $4.899 million in the first nine months of 2013, for a reduction of $3.884 million, or 79%. Gross charge-offs increased slightly for the third quarter due to charge-offs recorded when $5 million in nonperforming assets were sold, but declined on a year-to-date basis. A significant level of principal recoveries for both the quarter and year-to-date periods contributed to the relatively low level of net charge-offs in 2014. Additional factors which helped reduce our need for reserve replenishment via the loan loss provision in 2014 include the fact that many of our loan charge-offs have been recorded against reserves established in previous periods, and the fact that the credit quality of our performing loan portfolio continues to improve as newer loans have been underwritten utilizing more stringent criteria than older vintage loans.

The Company’s policies for monitoring the adequacy of the allowance and determining loan amounts that should be charged off, and other detailed information with regard to changes in the allowance, are discussed in note 12 to the consolidated financial statements and below under “Allowance for Loan and Lease Losses.” The process utilized to establish an appropriate allowance for loan and lease losses can result in a high degree of variability in the Company’s loan loss provision, and consequently in our net earnings.

NON-INTEREST INCOME and NON-INTEREST expense

The following table provides details on the Company’s non-interest income and non-interest expense for the three-month and nine-month periods ended September 30, 2014 and 2013 (dollars in thousands):

	Three months ended September 30,												Nine months ended September 30,
NON-INTEREST INCOME:	2014			% of Total			2013			% of Total			2014			% of Total			2013			% of Total
Service charges on deposit accounts	$	2,214			58.49	%	$	2,354			54.50	%	$	6,139			53.34	%	$	6,642			53.32	%
Other service charges, commissions & fees		1,359			35.90	%		1,420			32.88	%		4,144			36.00	%		4,283			34.39	%
Gains on sales of loans		-			-			24			0.56	%		3			0.03	%		92			0.74	%
Gains on securities		-			-			-			-			287			2.49	%		6			0.05	%
Loan servicing income		1			0.03	%		2			0.05	%		3			0.03	%		6			0.05	%
Bank owned life insurance		156			4.12	%		435			10.07	%		844			7.33	%		1,259			10.11	%
Other		55			1.46	%		84			1.94	%		90			0.78	%		168			1.34	%
Total non-interest income	$	3,785			100.00	%	$	4,319			100.00	%	$	11,510			100.00	%	$	12,456			100.00	%
As a % of average interest-earning assets ⁽¹⁾					1.11	%					1.39	%					1.16	%					1.34	%

NON-INTEREST EXPENSE:
Salaries and employee benefits	$	5,459			46.46	%	$	5,394			46.95	%	$	16,772			50.09	%	$	16,717			49.13	%
Occupancy costs
Furniture & equipment		458			3.90	%		455			3.96	%		1,378			4.12	%		1,489			4.38	%
Premises		1,204			10.25	%		1,099			9.56	%		3,322			9.92	%		3,213			9.44	%
Advertising and marketing costs		468			3.98	%		352			3.06	%		1,679			5.01	%		1,195			3.51	%
Data processing costs		673			5.73	%		404			3.52	%		1,937			5.78	%		1,166			3.43	%
Deposit services costs		657			5.59	%		619			5.39	%		1,935			5.78	%		1,832			5.38	%
Loan services costs
Loan processing		572			4.87	%		339			2.95	%		1,033			3.08	%		711			2.09	%
Foreclosed assets		51			0.43	%		887			7.72	%		(334	)		-1.00	%		1,679			4.93	%
Other operating costs
Telephone & data communications		329			2.80	%		350			3.05	%		804			2.40	%		1,223			3.59	%
Postage & mail		221			1.88	%		202			1.76	%		571			1.71	%		544			1.60	%
Other		147			1.25	%		241			2.09	%		499			1.49	%		529			1.55	%
Professional services costs
Legal & accounting		310			2.64	%		367			3.19	%		952			2.84	%		1,320			3.88	%
Other professional service		744			6.33	%		563			4.90	%		1,791			5.35	%		1,723			5.06	%
Stationery & supply costs		331			2.82	%		142			1.24	%		859			2.57	%		455			1.34	%
Sundry & tellers		126			1.07	%		76			0.66	%		288			0.86	%		231			0.69	%
Total non-interest expense	$	11,750			100.00	%	$	11,490			100.00	%	$	33,486			100.00	%	$	34,027			100.00	%
As a % of average interest-earning assets ⁽¹⁾					3.45	%					3.71	%					3.39	%					3.66	%
Efficiency Ratio ⁽²⁾		65.85	%					69.10	%					66.59	%					66.70	%

⁽¹⁾ Annualized

⁽²⁾ Tax Equivalent

Total non-interest income fell by $534,000, or 12%, for the comparative quarters and by $946,000, or 8%, for the comparative year-to-date periods. Both the third quarter and the first nine months were negatively impacted by a drop in income on bank-owned life insurance and lower service charges on deposits, although for the year-to-date period this was partially offset by gains on the sale of investment securities. Total non-interest income was an annualized 1.11% of average interest-earning assets in the third quarter of 2014 relative to 1.39% in the third quarter of 2013, and was 1.16% for the first nine months of 2014 relative to 1.34% for the first nine months of 2013. The lower ratio is due in part to an increase in average interest-earning assets.

Service charge income on deposits fell by $140,000, or 6%, for the quarterly comparison and by $503,000, or 8%, for the comparative nine-month periods due in large part to lower returned item and overdraft charges. The year-to-date period was also negatively impacted by certain non-recurring fee waivers made in the course of our core software conversion earlier in 2014. Other service charges, commissions, and fees also declined by $61,000, or 4%, for the quarter, and by $139,000, or 3%, for the year-to-date comparison. Lower fees on merchant accounts contributed to the decrease, including the impact of a $100,000 non-recurring incentive received in conjunction with our conversion to a new merchant processing vendor in the first quarter of 2013. Gains on the sale of loans were lower for both the quarter and the year-to-date period since the Company has been retaining all of the loans it originates. Loan servicing income has likewise dropped to insignificant levels in recent periods. We did not take any gains on the sale of investments in the third quarters of 2014 or 2013, but realized $287,000 in gains during the first nine months of 2014 relative to only $6,000 for the first nine months of 2013.

Bank-owned life insurance (BOLI) income fell by $279,000, or 64%, in the third quarter of 2014 relative to the third quarter of 2013 and by $415,000, or 33%, for the comparative year-to-date results, mainly due to fluctuations in income on BOLI associated with deferred compensation plans. The Company owns and derives income from two basic types of BOLI: “general account” and “separate account.” At September 30, 2014 the Company had $36.0 million invested in single-premium general account BOLI, which generates income that is used to fund expenses associated with executive salary continuation plans, director retirement plans and other employee benefits. Interest credit rates on general account BOLI do not change frequently and the income is typically fairly consistent, but rate reductions have led to slightly reduced income levels in recent periods. In addition to general account BOLI the Company had $4.4 million invested in separate account BOLI at September 30, 2014, which produces income that helps offset deferred compensation accruals for certain directors and senior officers. These deferred compensation BOLI accounts have returns pegged to participant-directed investment allocations that can include equity, bond, or real estate indices, and are thus subject to gains or losses which often contribute to significant fluctuations in income (and associated expense accruals). There was a loss on separate account BOLI totaling $82,000 in the third quarter of 2014 relative to a gain of $182,000 in the third quarter of 2013, for a quarter over quarter decrease of $264,000 in deferred compensation BOLI income. For the first nine months gains totaled $115,000 in 2014 relative to $496,000 in 2013, representing a reduction of $381,000. As noted, gains and losses on separate account BOLI are related to expense accruals or reversals associated with participant gains and losses on deferred compensation balances, thus their impact on taxable income tends to be neutral.

The “Other” category under non-interest income includes gains and losses on the disposition of assets other than OREO, rent on bank-owned property other than OREO, dividends on restricted stock, and other miscellaneous income. Pass-through expenses associated with our investments in low-income housing tax credit funds are netted against this income category. Other non-interest income was down $29,000 for the quarter and $78,000 for the first nine months. Negative pressures on other non-interest income include adjustments made to expenses associated with our low-income housing tax credit fund investments in 2014, and reductions totaling $42,000 for the third quarter and $60,000 for the year-to-date period in non-recurring gains on the disposition of equipment. Other non-interest income was favorably impacted by increases in dividends on restricted stock, totaling $76,000 for the third quarter and $112,000 year-to-date. Income generated through the Company’s alliance with Investment Centers of America (ICA) has also been included in Other Non-Interest Income, but the Company terminated its affiliation with ICA effective July 31, 2014 so related income was down $30,000 for the third quarter and $26,000 year-to-date. While non-interest income will continue to be negatively impacted in future periods, certain expenses associated with our ICA relationship will also be eliminated and the net financial impact on the Company is not expected to be material.

Total non-interest expense increased by $260,000, or 2%, in the third quarter of 2014 relative to the third quarter of 2013, but was down $541,000, or 2%, for the comparative nine-month periods. As detailed below, the increase for the quarter includes ongoing expenses incidental to our core banking software conversion in February 2014, non-recurring costs incurred in conjunction with our upcoming acquisition, and certain non-recurring costs associated with the sale of several nonperforming loans, offset in part by a reduction in net OREO costs. The year-to-date results were affected by the same items, but the reduction in net OREO expense more-than-offset the unfavorable variances for the year-to-date comparison. Non-interest expense improved to an annualized 3.45% of average interest-earning assets in the third quarter of 2014 relative to 3.71% in the third quarter of 2013, and was an annualized 3.39% of average interest-earning assets for the first nine months of 2014 relative to 3.66% for the first nine months of 2013.

The largest component of non-interest expense, salaries and employee benefits, reflects a quarter over quarter increase of $65,000, or 1%, and a year-to-date increase of only $55,000. Compensation expense was favorably impacted by lower stock option expense, which was down $43,000 for the quarter and $156,000 year-to-date, and lower deferred compensation expense accruals (related to the aforementioned decrease in BOLI income). Deferred compensation plan expense accruals for employee participants were negative $44,000 in the third quarter of 2014 relative to $114,000 in the third quarter of 2013, representing an absolute quarter-over-quarter decline of $158,000, and they were $105,000 for the first nine months of 2014 relative to $316,000 in the first nine months of 2013, for a year-to-date drop of $211,000. Fluctuations in the deferral of salaries directly related to successful loan originations had a negative impact on the quarterly comparison, dropping by $171,000, but a positive effect on the year-to-date comparison, increasing by $42,000. Group health insurance premiums were up $64,000 for the quarter and $121,000 for the year-to-date comparison. The year-to-date results were also negatively impacted by an increase of $177,000 in overtime costs, primarily consisting of non-recurring expenses incidental to our core conversion in February 2014. Salaries and benefits were 46.46% of total non-interest expense for the third quarter of 2014 relative to 46.95% in the third quarter of 2013, and were 50.09% for the first nine months of 2014 relative to 49.13% in the first nine months of 2013.

Total occupancy expense increased $108,000, or 7%, for quarterly comparison due mainly to higher maintenance/repair and utilities costs. Occupancy expense was roughly the same for the comparative nine-month periods, as additional expenses resulting from our rebranding project and our information technology network upgrade were offset by lower depreciation expense. Marketing costs rose by $116,000, or 33%, for the quarter and by $484,000, or 41%, for the first nine months, due in part to expenses associated with our recent rebranding project as well as the timing of certain payments. Data processing costs were up $269,000, or 67%, for the quarter and $771,000, or 66% for the first nine months due to an increase in our cost structure subsequent to the core conversion. Total deposit services costs increased by $38,000, or 6%, for the quarterly comparison and by $103,000, or 6%, for the first nine months due to conversion-related expense increases in electronic check exchange, mobile banking, and remote deposit capture, partially offset by a drop in merchant account interchange costs.

Total loan services costs reflect a drop of $603,000, or 49%, for the quarter and $1.691 million, or 71%, for the first nine months due in large part to lower net costs associated with foreclosed assets. Net costs on foreclosed assets, which include net gains/losses on the sale of foreclosed assets, OREO write-downs, OREO operating expense and rental income on OREO, were down $836,000, or 94%, for the third quarter and $2.013 million, or 120%, for the year-to-date period. These favorable variances were partially offset by approximately $300,000 in commissions and other costs paid in conjunction with the sale of nonperforming loans.

Telecommunications expense was down $21,000, or 6%, for the quarter and $419,000, or 34%, for the first nine months due to renegotiated billing rates, and the year-to-date period also reflects $155,000 in credits received earlier in 2014 for prior-period overpayments. Postage costs increased slightly in 2014 over 2013 due to an increase in the volume of mailings, while the “other” category under other operating costs fell by $94,000, or 39%, for the quarter and $30,000, or 6%, for the first nine months due in large part to lower recruiting and training costs in 2014.

Under professional services costs, legal and accounting costs declined by $57,000, or 16%, in the third quarter and by $368,000, or 28%, in the first nine months of 2014 due to lower legal costs for loan collections in 2014 and elevated loan review costs in the prior year. The cost of other professional services was up $181,000, or 32%, in the third quarter and increased $68,000, or 4%, for the first nine months, due to $267,000 in expenses related to our upcoming acquisition which were incurred in the third quarter of 2014. Favorable variances in this category include lower accruals for directors deferred compensation plans, which are related to the drop in BOLI income discussed above. Those accruals totaled only $11,000 in the third quarter of 2014 relative to $131,000 in the third quarter of 2013, and $113,000 in the first nine months of 2014 relative to $316,000 for the same time period in 2013. Stationery and supply costs increased by $189,000, or 133%, for the third quarter and $404,000, or 89%, for the first nine months of 2014, due to higher recurring costs stemming from our core conversion and certain non-recurring costs associated with our rebranding effort. Sundry and teller losses increased by $50,000, or 66%, for the third quarter and $57,000, or 25%, for the first nine months, due to an increase in operational and debit card losses.

The Company’s tax-equivalent overhead efficiency ratio was 65.85% in the third quarter of 2014 relative to 69.10% in the third quarter of 2013, and was 66.59% for the first nine months of 2014 as compared to 66.70% for the first nine months of 2013. The overhead efficiency ratio represents total non-interest expense divided by the sum of fully tax-equivalent net interest and non-interest income, with the provision for loan losses, investment gains/losses, OREO gains/losses, acquisition costs and certain other extraordinary items excluded from the equation.

PROVISION FOR INCOME TAXES

The Company sets aside a provision for income taxes on a monthly basis. The amount of that provision is determined by first applying the Company’s statutory income tax rates to estimated taxable income, which is pre-tax book income adjusted for permanent differences, and then subtracting available tax credits. Permanent differences include but are not limited to tax-exempt interest income, BOLI income, California Enterprise Zone deductions, and certain book expenses that are not allowed as tax deductions. BOLI income was lower for the third quarter and the first nine months in 2014, as discussed above, while interest income on municipal securities increased by 4% for the quarterly comparison and 11% for the comparative year-to-date periods. Our tax credits consist primarily of those generated by investments in low-income housing tax credit funds, and California state employment tax credits. Effective January 1, 2014, changes in California tax law eliminated certain state income tax credits and deductions, which had a negative impact on our tax accrual rate.

Because of the relatively high portion of the Company’s pretax income that consists of tax-exempt interest income and BOLI income, and the level of tax credits available in relation to our pre-credit tax liability as calculated for book purposes, our tax accrual rate is currently very sensitive to changes in pretax income. In addition, subsequent to filing our prior-year income tax returns in the third quarter of 2014 we adjusted our year-to-date tax accrual to reflect updated expectations with regard to actual tax rates, which resulted in a tax accrual increase of $310,000 for 2014. The referenced factors resulted in an income tax provision of $1.776 million, or 33% of pre-tax income in the third quarter of 2014, relative to a provision of $663,000, or 16% of pre-tax income in the third quarter of 2013. For the first nine months our tax provision was $4.543 million, or 28% of pre-tax income in 2014, relative to $2.198 million, or 19% of pre-tax income in 2013.

balance sheet analysis

EARNING ASSETS

The Company’s interest-earning assets are comprised of investments and loans, and the composition, growth characteristics, and credit quality of both are significant determinants of the Company’s financial condition. Investments are analyzed in the section immediately below, while the loan and lease portfolio and other factors affecting earning assets are discussed in the sections following investments.

INVESTMENTS

The Company’s investments consist of debt securities and marketable equity securities (together, the “investment portfolio”), investments in the time deposits of other banks, surplus interest-earning balances in our Federal Reserve Bank (FRB) account, and overnight fed funds sold. Surplus FRB balances and fed funds sold to correspondent banks represent the temporary investment of excess liquidity. The Company’s investments serve several purposes: 1) they provide liquidity to even out cash flows from the loan and deposit activities of customers; 2) they provide a source of pledged assets for securing public deposits, bankruptcy deposits and certain borrowed funds which require collateral; 3) they constitute a large base of assets with maturity and interest rate characteristics that can be changed more readily than the loan portfolio, to better match changes in the deposit base and other funding sources of the Company; 4) they are an alternative interest-earning use of funds when loan demand is light; and 5) they can provide partially tax exempt income. Aggregate investments totaled $470 million, or 32% of total assets at September 30, 2014, compared to $452 million, or 32% of total assets at December 31, 2013.

We had no fed funds sold at September 30, 2014 or December 31, 2013, and interest-bearing balances at other banks dropped to $2 million at September 30, 2014 from $27 million at December 31, 2013 as excess liquidity was invested in higher-yielding longer-term bonds. The Company’s investment portfolio reflects an increase of $43 million, or 10%, for the first nine months of 2014, ending the period with a book balance of $468 million. The Company carries investments at their fair market values. Although we currently have the intent and ability to hold our investment securities to maturity, the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management.

The following table sets forth the amortized cost and fair market value of Company’s investment portfolio by investment type as of the dates noted:

Investment Portfolio
(dollars in thousands, unaudited)	September 30, 2014				December 31, 2013

	Amortized		Fair Market		Amortized		Fair Market
	Cost		Value		Cost		Value
Available for Sale
US Government agencies & corporations	$	4,464	$	4,389	$	5,395	$	5,304
Mortgage-backed securities		359,954		362,114		320,223		320,721
State & political subdivisions		96,199		98,623		97,361		96,563
Equity securities		1,373		2,562		1,336		2,456
Total investment securities	$	461,990	$	467,688	$	424,315	$	425,044

The net unrealized gain on our investment portfolio, or the difference between the fair market value and amortized cost, was $5.7 million at September 30, 2014, up from $729,000 at December 31, 2013 due to higher market values resulting from lower long-term interest rates. The balance of mortgage-backed securities increased by $41 million, or 13%, during t