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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2006
Commission file number: 000-33063
SIERRA BANCORP
(Exact name of registrant as specified in its charter)
| California | 33-0937517 | |
| State of incorporation | I.R.S. Employer Identification Number |
| 86 North Main Street Porterville, California |
93257 | |
| Address of principal executive offices | Zip Code |
(559) 782-4900
Registrant’s telephone number, including area code
Securities registered pursuant to Section 12(b) of the Act: Common Stock, No Par Value
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. ¨ Yes x No
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. ¨ Yes x No
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. x Yes ¨ No
Check if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this form 10-K. ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). ¨ Yes x No
As of June 30, 2006, the last business day of Registrant’s most recently completed second fiscal quarter, the aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $156 million, based on the closing price reported to the Registrant on that date of $26.22 per share.
Shares of Common Stock held by each officer and director and each person owning more than five percent of the outstanding Common Stock have been excluded in that such persons may be deemed to be affiliates. This determination of the affiliate status is not necessarily a conclusive determination for other purposes.
The number of shares of Common Stock of the registrant outstanding as of January 31, 2007 was 9,721,654.
Documents Incorporated by Reference: Portions of the definitive proxy statement for the 2007 Annual Meeting of Shareholders to be filed with the Securities and Exchange Commission pursuant to SEC Regulation 14A are incorporated by reference in Part III, Items 10-14.
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| ITEM 1. | BUSINESS |
General
The Company
Sierra Bancorp (the “Company”) is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended, and is headquartered in Porterville, California. The Company was incorporated in November 2000 and acquired all of the outstanding shares of Bank of the Sierra (the “Bank”) in August 2001. The Company’s principal subsidiary is the Bank, and 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 direct 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”). This additional regulatory capital has enabled the Company to stay on track with expansion plans while maintaining its classification as a “well-capitalized” institution. Pursuant to FASB Interpretation No. 46, Consolidation of Variable Interest Entities (FIN 46), Sierra Statutory Trust II and Sierra Capital Trust III are not reflected on a consolidated basis in the financial statements of the Company.
The Company’s principal source of income is dividends from the Bank, although supplemental sources of income may be explored in the future. The expenditures of the Company, including (but not limited to) the payment of dividends to shareholders, if and when declared by the Board of Directors, the cost of servicing debt, legal fees, audit fees, and shareholder costs will generally be paid from dividends paid to the Company by the Bank.
At December 31, 2006, the Company had consolidated assets of $1.2 billion, deposits of $868 million and shareholders’ equity of $90 million. The Company’s liabilities include $30 million in debt obligations due to Sierra Statutory Trust II and Sierra Capital Trust III, related to TRUPS issued by those entities.
References herein to the “Company” include the Company and its consolidated subsidiary, unless the context indicates otherwise.
The Bank
The Bank is a California state-chartered bank headquartered in Porterville, California. It was incorporated in September 1977 and opened for business in January 1978, and 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. The Bank is a multi-community independent bank that offers a full range of banking services to individuals and businesses primarily in the central and southern sections of California’s San Joaquin Valley. We operate twenty full service branch offices throughout this geographic footprint. The Bank’s two newest branches commenced operations in Reedley in December 2005 and Bakersfield in February 2006, and our next branch is expected to open in the city of Delano in the first quarter of 2007. We have also received regulatory approvals for a fourth Bakersfield branch, which could possibly open during the fourth quarter of 2007. The locations of the Bank’s current offices are:
| Porterville: | Administrative Headquarters 86 North Main Street |
Main Office 90 North Main Street |
West Olive Branch 1498 West Olive Avenue | |||
| Bakersfield: | Bakersfield California Office 5060 California Avenue |
Bakersfield Ming Office 8500 Ming Avenue |
Bakersfield Riverlakes Office 4060 Coffee Road | |||
| California City: | California City Office 8031 California City Blvd. |
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| Clovis: | Clovis Office 1710 Clovis Avenue |
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| Dinuba: | Dinuba Office 401 East Tulare Street |
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| Exeter: | Exeter Office 1103 West Visalia Road |
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| Fresno: | Fresno Shaw Office 636 East Shaw Avenue |
Fresno Herndon Office 7029 N. Ingram Avenue |
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| Hanford: | Hanford Office 427 West Lacey Boulevard |
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| Lindsay: | Lindsay Office 142 South Mirage Avenue |
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| Reedley: | Reedley Office 1095 W. Manning Street |
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| Tehachapi: | Tehachapi Downtown Office 224 West “F” Street |
Tehachapi Old Town Office 21000 Mission Street |
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| Three Rivers: | Three Rivers Office 40884 Sierra Drive |
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| Tulare: | Tulare Office 246 East Tulare Avenue |
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| Visalia: | Visalia Mooney Office 2515 South Mooney Blvd. |
Visalia Downtown Office 128 East Main Street |
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The Bank’s gross loan and lease balances at the end of 2006 totaled $888 million. The Bank’s lending activities are well-diversified and include real estate, commercial (including small business), agricultural, and consumer loans. The bulk of our real estate loans are secured by commercial or professional office properties which are predominantly owner-occupied. In addition, we staff our Fresno, Visalia, Porterville, and Bakersfield offices with real estate lending specialists who are responsible for a complete line of land acquisition and development loans, construction loans for residential and commercial development, and multifamily credit facilities. Secondary market services are provided through the Bank’s affiliations with Freddie Mac, Fannie Mae and various non-governmental programs. To round out our real estate lending products we have an arrangement with Genpact Mortgage Services (formerly Moneyline Lending Services), whereby Genpact underwrites single-family mortgage loans for qualifying Bank customers referred to them via Bank-branded delivery channels (i.e., Bank branches, the Bank’s internet site, and a dedicated telephone line).
Agricultural Credit Centers located in Fresno and Porterville provide a complete line of credit services in support of the agricultural activities that are key to the continued economic development of the communities we serve. “Ag lending” clients include a full range of individual farming customers, small business farming organizations, and major corporate farming units. We also actively engage in Small Business Administration (“SBA”) lending. We have been designated as an SBA Preferred Lender since 1999, and Bank of the Sierra is a participant in the SBA’s innovative “Community Express” program. Another service provided to business customers is equipment leasing, and we offer both direct finance and operating leases through our Leasing Division. Our principal retail lending services include home equity lines, consumer loans, and credit card loans.
As of December 31, 2006, the percentage of our total loan and lease portfolio for each of the principal areas in which we directed our lending activities were as follows: (i) loans secured by real estate (73.4%); (ii) commercial and industrial loans (including SBA loans and commercial credit card balances) (15.7%); (iii) consumer loans (6.1%); (iv) direct finance leases (2.3%); (v) agricultural production loans (1.5%); and (vi) consumer credit cards (1.0%). Real estate loans and related activities generated total revenue of $51.9 million in 2006 and $40.0 million in 2005. Interest and fees on real-estate secured loans and loan sale income totaled approximately 56% of our total interest and other income for 2006 and 54% in 2005.
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In addition to loans, we offer a wide range of deposit products for retail and business banking markets including checking accounts, interest-bearing transaction accounts, savings accounts (including money market demand accounts), time deposits, retirement accounts, and sweep accounts (sweep products facilitate more efficient cash management for our business customers, by automatically sweeping idle cash from demand deposit accounts into interest-bearing repos or money market deposit accounts). Telephone banking and internet banking with bill-pay are options for our deposit customers, and we expect to soon have the ability to open deposit accounts online. Remote deposit capture capabilities were also recently developed, to allow our business customers to send their check deposits to us electronically. We attract deposits from throughout our market area with a customer-oriented product mix, competitive pricing, convenient locations, and drive-up banking, all provided with the highest level of customer service. At December 31, 2006 we had 60,788 deposit accounts totaling $868 million, including brokered deposits, compared to 58,620 deposit accounts totaling $816 million as of December 31, 2005.
We offer a multitude of other products and services to complement our lending and deposit services. These include installment note collection, cashier’s checks, traveler’s checks, gift cards, bank-by-mail, ATM, night depository, safe deposit boxes, direct deposit, automated payroll services, electronic funds transfers, on-line banking, and other customary banking services. To facilitate customer convenience by allowing cash withdrawal and deposit options at locations other than branches, we currently operate offsite ATM’s at seven different locations and utilize a mobile ATM unit at fairs, exhibitions, and various other community functions within our market area. We have a Spanish language option on our own network of ATM’s, and shared ATM and Point of Sale (POS) networks allow our customers access to national and international funds transfer networks. In addition, we have established a convenient customer service group accessible by toll-free telephone to answer questions and provide a high level of customer service.
In order to provide non-deposit investment options we have developed a strategic alliance with Investment Centers of America, Inc. of Bismarck, North Dakota (“ICA”). Through this arrangement, registered and licensed representatives of ICA provide our customers with convenient access to annuities, insurance products, mutual funds, and a full range of investment products. They conduct business from offices located in our Porterville, Visalia, Tulare, Tehachapi and Fresno branches.
We have not engaged in any material research activities related to the development of new products or services during the last two fiscal years. However, our officers and employees are continually searching for ways to increase public convenience, enhance public access to the electronic payments system, and enable us to improve our competitive position. In 2007, for example, as noted above we plan to enhance our internet site to include the ability to open deposit accounts online, and we expect to ultimately leverage this capability into an online branch, although no assurance can be given in that regard. In 2006, we added a money market deposit account sweep product and developed remote deposit capture capabilities for the convenience of business customers, in addition to opening another Bakersfield branch. In 2005, we researched health savings accounts and began offering them to customers, implemented a gift card product, and opened a new branch in the city of Reedley. The cost to the Bank for these development, operations, and marketing activities cannot be specifically calculated with any degree of certainty.
We hold no patents or licenses (other than licenses required by appropriate bank regulatory agencies), franchises, or concessions. Our business has a modest seasonal component due to the heavy agricultural orientation of the Central Valley. As our branches in more metropolitan areas such as Fresno and Bakersfield have expanded, however, the agriculture-related base has become less important. We are not dependent on a single customer or group of related customers for a material portion of our deposits, nor is a material portion of our loans concentrated within a single industry or group of related industries. The amounts expended on compliance with new government and regulatory initiatives related to anti-terrorism, corporate responsibility, and customer privacy have not been insignificant. However, as far as can be reasonably determined there has been no material effect upon our capital expenditures, earnings, or competitive position as a result of Federal, state, or local environmental regulation.
Recent Developments
On March 15, 2007, the Company’s Board of Directors approved the 2007 Stock Incentive Plan (the “2007 Plan”), which is subject to the further approval of the Company’s shareholders. The 2007 Plan provides for the issuance of
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both “incentive” and “nonqualified” stock options to officers and employees, and of “nonqualified” stock options to non-employee directors, of the Company and its subsidiaries. The 2007 Plan also provides for the issuance of restricted stock awards to these same classes of eligible participants, which awards may be granted on such terms and conditions as are established by the Board of Directors or the Compensation Committee in its discretion. The maximum number of shares to be issued under the 2007 Plan is 1,500,000 shares of the Company’s authorized but unissued common stock, subject to adjustment for stock splits and dividends. The Company’s 1998 Stock Option Plan (“1998 Plan”) will be terminated on the date shareholder approval of the 2007 Plan is obtained, but the options granted and still outstanding under the 1998 Plan will not be affected.
On December 8, 2006, Sierra Capital Trust I, a wholly-owned subsidiary of the Company, redeemed 100% of its $15 million in TRUPS that were issued on November 28, 2001 with a maturity date of December 8, 2031, as allowed by the early redemption provisions of the TRUPS transaction documents. Concurrently, the Company retired the junior subordinated debentures issued to Sierra Capital Trust I that became due and payable upon redemption of the TRUPS, after which Sierra Capital Trust I returned $464,000 in capital to the Company in exchange for the cancellation of common securities in that amount and was subsequently dissolved. The replacement of the TRUPS redeemed on December 8, 2006 was “pre-funded” by the issuance of $15 million in lower-cost TRUPS by a newly formed subsidiary, Sierra Capital Trust III, on June 15, 2006. Further details on these recently-issued TRUPS can be found in Note 10 to the Financial Statements located in Item 8 herein.
In December 2006, the Bank entered into an agreement with First Data Merchant Service Corporation (“First Data”), whereby electronic payments and services for the Company’s merchant customers will be outsourced to First Data commencing in the spring of 2007. This is expected to result in a wider array of products and improved service for our merchant customers, and should ultimately help expand our customer base. The outsourcing arrangement resulted in a $100,000 gain to the Company in December 2006 and allows for the ongoing receipt of limited referral and transaction fees from First Data.
The Company also recently converted from Digital Insight to Precision Computer Systems (“PCS”) for its internet banking platform. This switch is expected to result in an annual expense reduction of over $200,000 per year starting in 2007, but required the payment of a $358,000 early termination fee to Digital Insight in December 2006.
Another recent development is an initiative aimed at increasing consumer checking account balances. This initiative, which involves the formulation of a new deposit account line-up, multiple direct mail campaigns, and extensive training for front-line personnel, could add as much as $800,000 to the Company’s operating expense (primarily marketing costs) in 2007 relative to 2006. The training commenced in late 2006, while the initial marketing pieces were mailed and the new account line-up was implemented in January 2007.
Recent Accounting Pronouncements
Information on recent accounting pronouncements is contained in Footnote 2 to the Financial Statements.
Competition
The banking business in California in general, and specifically in many of our market areas, is highly competitive with respect to virtually all products and services. The industry continues to consolidate, and unregulated competitors have entered banking markets with products targeted at highly profitable customer segments. Many largely unregulated competitors are able to compete across geographic boundaries, and provide customers with meaningful alternatives to nearly all significant banking services and products. These competitive trends are likely to continue.
With respect to commercial bank competitors, the business is dominated by a relatively small number of major banks that operate a large number of offices within our geographic footprint. For the combined Tulare, Kern, Fresno, and Kings county region, the four counties within which the Company operates, the top six institutions are all multi-billion dollar entities with an aggregate of 161 offices that control a combined 64.1% of deposit market share based on June 30, 2006 FDIC market share data. Bank of the Sierra ranks seventh with a 4.5% share of total deposits. In Tulare County, however, where the Bank was originally formed, we rank first for total number of branch locations
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(9), and second for deposit market share with 16.7% of total deposits, behind only Bank of America (22.3%). The largest portion of deposits in the combined four-county area also belongs to Bank of America (23.9%), followed by Wells Fargo (14.0%) and Washington Mutual (8.1%). Fremont Investment & Loan, Union Bank of California, and Citibank round out the top six. These banks have, among other advantages, the ability to finance wide-ranging advertising campaigns and to allocate their resources to regions of highest yield and demand. They can also offer certain services that we do not offer directly but may offer indirectly through correspondent institutions. By virtue of their greater total capitalization, these banks also have substantially higher lending limits than we do. For customers whose needs exceed our legal lending limit, we arrange for the sale, or “participation”, of some of the balances to financial institutions that are not within our geographic footprint.
In addition to other banks, our competitors include savings institutions, credit unions, and numerous non-banking institutions such as finance companies, leasing companies, insurance companies, brokerage firms, and investment banking firms. In recent years, we have also witnessed increased competition from specialized companies that offer wholesale finance, credit card, and other consumer finance services, as well as services that circumvent the banking system by facilitating payments via the internet, wireless devices, prepaid cards, or other means. Technological innovations have lowered traditional barriers of entry and enabled many of these companies to compete in financial services markets. Such innovation has, for example, made it possible for non-depository institutions to offer customers automated transfer payment services that previously were considered traditional banking products. In addition, many customers now expect a choice of delivery channels, including telephone, mail, personal computer, ATMs, self-service branches, and/or in-store branches. Competitors offering such products include traditional banks and savings associations, credit unions, brokerage firms, asset management groups, finance and insurance companies, internet-based companies, and mortgage banking firms.
Strong competition for deposits and loans among financial institutions and non-banks alike affects interest rates and other terms on which financial products are offered to customers. Mergers between financial institutions have placed additional pressure on other banks within the industry to remain competitive by streamlining operations, reducing expenses, and increasing revenues. Competition has also intensified due to federal and state interstate banking laws enacted in the mid-1990’s, which permit banking organizations to expand into other states. The relatively large and expanding California market has been particularly attractive to out-of-state institutions. The Financial Modernization Act, effective March 11, 2000 (see “– Regulation and Supervision – Financial Modernization Act”), has made it possible for full affiliations to occur between banks and securities firms, insurance companies, and other financial companies, and has also intensified competitive conditions.
Our credit card business is subject to an even higher level of competitive pressure than our general banking business. There are a number of major banks and credit card issuers that are able to finance broad product lines and highly visible and extremely successful advertising campaigns, with which community banks generally do not have the resources to compete. Additional competition comes from many non-financial institutions, such as retailers that offer credit cards. As a result, our credit card accounts and outstanding balances are likely to increase at a slower rate than for nationwide issuers.
For years we have countered rising competition by offering a broad array of products in an innovative and flexible manner. We are able to offer our customers community-oriented, personalized service that cannot always be matched by the major banks. We rely on local promotional activity, personal contacts by our officers, directors, employees, and shareholders, and individualized service provided through accommodative policies. This approach appears to be well-received by the populace of the San Joaquin Valley, who appreciate a high-touch, customer-oriented environment in which to conduct their financial transactions. Other competitive advantages include our retention of drive-up teller windows, which have been eliminated by much of the competition, and our “preferred lender” or “PLP” status with the Small Business Administration, which enables us to approve SBA loans faster than many of our competitors. Layered on top of the Company’s traditional personal-contact banking philosophy are sophisticated telephone banking, internet banking, and online bill payment capabilities, which were initiated to meet the needs of customers with electronic access requirements and provide automated 24-hour banking. This high-tech and high-touch approach allows individuals to customize access to the Company to their particular preference.
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Employees
As of December 31, 2006 the Company had 288 full-time and 93 part-time employees. On a full time equivalent basis, staffing stood at 361 at December 31, 2006, as compared to 351 at December 31, 2005, an increase caused mainly by the addition of staff during 2006 for the new Bakersfield office.
Regulation and Supervision
The Company and the Bank are subject to significant regulation by federal and state regulatory agencies. The following discussion of statutes and regulations is only a brief summary and does not purport to be complete. This discussion is qualified in its entirety by reference to such statutes and regulations. No assurance can be given that such statutes or regulations will not change in the future.
The Company
The Company’s stock is traded on the NASDAQ Global Select Market under the symbol BSRR, and as such the Company is subject to NASDAQ rules and regulations including those related to corporate governance. The Company is also subject to the periodic reporting requirements of Section 13 of the Securities Exchange Act of 1934 (the “Exchange Act”) which requires the Company to file annual, quarterly and other current reports with the Securities and Exchange Commission (the “SEC”). The Company is subject to additional regulations including, but not limited to, the proxy and tender offer rules promulgated by the SEC under Sections 13 and 14 of the Exchange Act; the reporting requirements of directors, executive officers and principal shareholders regarding transactions in the Company’s Common Stock and short-swing profits rules promulgated by the SEC under Section 16 of the Exchange Act; and certain additional reporting requirements by principal shareholders of the Company promulgated by the SEC under Section 13 of the Exchange Act. As a publicly traded company which had more than $75 million in public float as of June 30, 2006, the Company is classified as an “accelerated filer.” In addition to accelerated time frames for filing SEC periodic reports, this also means that the Company is subject to the requirements of Section 404 of the Sarbanes-Oxley Act of 2002 with regard to documenting, testing, and attesting to internal controls over financial reporting.
The Company is a bank holding company within the meaning of the Bank Holding Company Act of 1956 and is registered as such with the Federal Reserve Board. A bank holding company is required to file with the Federal Reserve Board annual reports and other information regarding its business operations and those of its subsidiaries. It is also subject to periodic examination by the Federal Reserve Board and is required to obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of any voting shares of any bank if, after such acquisition, it would directly or indirectly own or control more than 5% of the voting stock of that bank, unless it already owns a majority of the voting stock of that bank.
The Federal Reserve Board has by regulation determined certain activities in which a bank holding company may or may not conduct business. A bank holding company must engage, with certain exceptions, in the business of banking or managing or controlling banks or furnishing services to or performing services for its subsidiary banks. The permissible activities and affiliations of certain bank holding companies were expanded in 2000 by the Financial Modernization Act. (See “– Financial Modernization Act” below.)
The Company and the Bank are deemed to be affiliates of each other within the meaning set forth in the Federal Reserve Act and are subject to Sections 23A and 23B of the Federal Reserve Act. This means, for example, that there are limitations on loans by the Bank to affiliates, and that all affiliate transactions must satisfy certain limitations and otherwise be on terms and conditions at least as favorable to the Bank as would be available for non-affiliates.
The Federal Reserve Board has a policy that bank holding companies must serve as a source of financial and managerial strength to their subsidiary banks. It is the Federal Reserve Bank’s position that bank holding companies should stand ready to use their available resources to provide adequate capital to their subsidiary banks during periods of financial stress or adversity. Bank holding companies should also maintain the financial flexibility and capital-raising capacity to obtain additional resources for assisting their subsidiary banks.
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The Federal Reserve Board also has the authority to regulate bank holding company debt, including the authority to impose interest rate ceilings and reserve requirements on such debt. Under certain circumstances, the Federal Reserve Board may require the Company to file written notice and obtain its approval prior to purchasing or redeeming the Company’s equity securities. The Company’s existing stock repurchase program (see “Item 5—Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities – Stock Repurchases”) is not subject to any such notification or approval requirements.
The Bank
As a California state-chartered bank whose accounts are insured by the FDIC, the Bank is subject to regulation, supervision and regular examination by the California Department of Financial Institutions (the “DFI”) and the FDIC. In addition, while the Bank is not a member of the Federal Reserve System, it is subject to certain regulations of the Federal Reserve Board. The regulations of these agencies govern most aspects of the Bank’s business, including the making of periodic reports by the Bank, and the Bank’s activities relating to dividends, investments, loans, borrowings, capital requirements, certain check-clearing activities, branching, mergers and acquisitions, reserves against deposits and numerous other areas. Supervision and examination of the Bank by the FDIC and any legal actions taken by the FDIC with respect thereto are generally intended to protect depositors and are not intended for the protection of shareholders.
The earnings and growth of the Bank are largely dependent on its ability to maintain a favorable differential or “spread” between the yield on its interest-earning assets and the rates paid on its deposits and other interest-bearing liabilities. As a result, the Bank’s performance is influenced by general economic conditions, both domestic and foreign, the monetary and fiscal policies of the federal government, and the policies of the regulatory agencies, particularly the Federal Reserve Board. The Federal Reserve Board implements national monetary policies (such as seeking to curb inflation and combat recession) by means of open-market operations in United States Government securities, adjusting the required level of reserves for financial institutions subject to its reserve requirements, and varying the discount rate applicable to borrowings by banks that are members of the Federal Reserve System. The actions of the Federal Reserve Board in these areas influence the growth of bank loans, investments and deposits and also affect interest rates on loans and deposits. The nature and impact of any future changes in monetary policies cannot be predicted.
Capital Adequacy Requirements
The Company and the Bank are subject to the regulations of the Federal Reserve Board and the FDIC, respectively, governing capital adequacy. Each of the federal regulators has established risk-based and leverage capital guidelines for the banks or bank holding companies it regulates, which set total capital requirements and define capital in terms of “core capital elements,” or Tier 1 capital; and “supplemental capital elements,” or Tier 2 capital. Tier 1 capital is generally defined as the sum of the core capital elements less goodwill and certain other deductions, notably the unrealized net gains or losses (after tax adjustments) on available for sale investment securities carried at fair market value. The following items are defined as core capital elements: (i) common shareholders’ equity; (ii) qualifying non-cumulative perpetual preferred stock and related surplus (not to exceed 25% of tier 1 capital plus goodwill); and (iii) minority interests in the equity accounts of consolidated subsidiaries. At December 31, 2006, approximately one-fourth of the Company’s Tier 1 capital consisted of trust preferred securities, however no assurance can be given that trust preferred securities will continue to be treated as Tier 1 capital in the future. Tier 2 capital can include: (i) allowance for loan and lease losses (but not more than 1.25% of an institution’s risk-weighted assets); (ii) perpetual preferred stock and related surplus not qualifying as core capital; (iii) hybrid capital instruments, perpetual debt and mandatory convertible debt instruments; and (iv) term subordinated debt and intermediate-term preferred stock and related surplus (but not more than 50% of Tier 1 capital). The maximum amount of Tier 2 capital that may be recognized for risk-based capital purposes is limited to 100% of Tier 1 capital, net of goodwill.
The minimum required ratio of qualifying total capital to total risk-weighted assets is 8% (“Total Risk-Based Capital Ratio”), at least one-half of which must be in the form of Tier 1 capital, and the minimum required ratio of Tier 1 capital to total risk-weighted assets is 4% (“Tier 1 Risk-Based Capital Ratio”). Risk-based capital ratios are
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calculated to provide a measure of capital that reflects the degree of risk associated with a banking organization’s operations for both transactions reported on the balance sheet as assets, and transactions, such as letters of credit and recourse arrangements, which are recorded as off-balance sheet items. Under risk-based capital guidelines, the nominal dollar amounts of assets and credit-equivalent amounts of off-balance sheet items are multiplied by one of several risk adjustment percentages, which range from 0% for assets with low credit risk, such as certain U.S. Treasury securities, to 100% for assets with relatively high credit risk, such as unsecured loans. As of December 31, 2006 and 2005, Bank-only Total Risk-Based Capital Ratios were 12.49% and 12.46%, respectively, and the Bank’s Tier 1 Risk-Based Capital Ratios were 11.31% and 11.34%, respectively. As of December 31, 2006 and 2005, the consolidated Company’s Total Risk-Based Capital Ratios were 12.98% and 13.50%, respectively, and its Tier 1 Risk-Based Capital Ratios were 11.77% and 12.01%, respectively.
The risk-based capital requirements also take into account concentrations of credit involving collateral or loan type, and the risks of “non-traditional” activities (those that have not customarily been part of the banking business). The regulations require institutions with high or inordinate levels of risk to operate with higher minimum capital standards, and authorize the regulators to review an institution’s management of such risks in assessing an institution’s capital adequacy. Additionally, the regulatory Statements of Policy on risk-based capital regulations include exposure to interest rate risk as a factor that the regulators will consider in evaluating a bank’s capital adequacy, although interest rate risk does not impact the calculation of a bank’s risk-based capital ratios. Interest rate risk is the exposure of a bank’s current and future earnings and equity capital to adverse movement in interest rates. While interest risk is inherent in a bank’s role as financial intermediary, it introduces volatility to earnings and to the economic value of the bank.
The FDIC and the Federal Reserve Board also require financial institutions to report a leverage ratio, defined as Tier 1 capital (net of all intangibles) to adjusted total assets. Banks and bank holding companies that have received the highest rating of the five categories used by regulators to rate banks and are not anticipating or experiencing any significant growth must maintain a leverage ratio of at least 3%. All other institutions are required to maintain a leverage ratio of at least 4% to 5%. Pursuant to federal regulations, banks must maintain capital levels commensurate with the level of risk to which they are exposed, including the volume and severity of problem loans, and federal regulators may set higher capital requirements when a bank’s particular circumstances warrant. Bank-only Leverage Capital Ratios were 9.53% and 9.31% on December 31, 2006 and 2005, respectively. As of December 31, 2006 and 2005, the consolidated Company’s leverage capital ratios were 9.92% and 9.87%, respectively. All of the above ratios exceeded regulatory minimums.
For more information on the Company’s capital, see Part II, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operation – Capital Resources. Risk-based capital ratio requirements are discussed in greater detail in the following section.
Prompt Corrective Action Provisions
Federal law requires each federal banking agency to take prompt corrective action to resolve the problems of insured financial institutions, including but not limited to those that fall below one or more prescribed minimum capital ratios. The federal banking agencies have by regulation defined the following five capital categories: “well capitalized” (Total Risk-Based Capital Ratio of 10%; Tier 1 Risk-Based Capital Ratio of 6%; and Leverage Ratio of 5%); “adequately capitalized” (Total Risk-Based Capital Ratio of 8%; Tier 1 Risk-Based Capital Ratio of 4%; and Leverage Ratio of 4%, or 3% if the institution receives the highest rating from its primary regulator); “undercapitalized” (Total Risk-Based Capital Ratio of less than 8%; Tier 1 Risk-Based Capital Ratio of less than 4%; or Leverage Ratio of less than 4%, or 3% if the institution receives the highest rating from its primary regulator); “significantly undercapitalized” (Total Risk-Based Capital Ratio of less than 6%; Tier 1 Risk-Based Capital Ratio of less than 3%; or Leverage Ratio less than 3%); and “critically undercapitalized” (tangible equity to total assets less than 2%). As of December 31, 2006 and 2005, the Bank was deemed to be well capitalized for regulatory capital purposes. A bank may be treated as though it were in the next lower capital category if after notice and the opportunity for a hearing, the appropriate federal agency finds an unsafe or unsound condition or practice so warrants, but no bank may be treated as “critically undercapitalized” unless its actual capital ratio warrants such treatment.
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At each successively lower capital category, an insured bank is subject to increased restrictions on its operations. For example, a bank is generally prohibited from paying management fees to any controlling persons or from making capital distributions if to do so would make the bank “undercapitalized.” Asset growth and branching restrictions apply to undercapitalized banks, which are required to submit written capital restoration plans meeting specified requirements (including a guarantee by the parent holding company, if any). “Significantly undercapitalized” banks are subject to broad regulatory authority, including among other things, capital directives, forced mergers, restrictions on the rates of interest they may pay on deposits, restrictions on asset growth and activities, and prohibitions on paying bonuses or increasing compensation to senior executive officers without FDIC approval. Even more severe restrictions apply to critically undercapitalized banks. Most importantly, except under limited circumstances, not later than 90 days after an insured bank becomes critically undercapitalized the appropriate federal banking agency is required to appoint a conservator or receiver for the bank.
In addition to measures taken under the prompt corrective action provisions, insured banks may be subject to potential actions by the federal regulators for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation or any condition imposed in writing by the agency or any written agreement with the agency. Enforcement actions may include the issuance of cease and desist orders, termination of insurance of deposits (in the case of a bank), the imposition of civil money penalties, the issuance of directives to increase capital, formal and informal agreements, or removal and prohibition orders against “institution-affiliated” parties.
Safety and Soundness Standards
The federal banking agencies have also adopted guidelines establishing safety and soundness standards for all insured depository institutions. Those guidelines relate to internal controls, information systems, internal audit systems, loan underwriting and documentation, compensation and interest rate exposure. In general, the standards are designed to assist the federal banking agencies in identifying and addressing problems at insured depository institutions before capital becomes impaired. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan and institute enforcement proceedings if an acceptable compliance plan is not submitted.
Insurance of Deposit Accounts
The Bank’s deposit accounts are insured by the FDIC and are therefore subject to FDIC deposit insurance assessments. The FDIC Reform Act of 2005, which was enacted in February 2006, merged the Bank Insurance Fund and the Savings Association Insurance Fund into one fund (the “Deposit Insurance Fund”); increased insurance coverage for retirement accounts to $250,000; indexed the deposit insurance levels for inflation every five years; changed the designated reserve ratio for the Deposit Insurance Fund to a range of between 1.15% and 1.50% of estimated insured deposits; and required the FDIC to provide cash rebates to insured institutions under certain circumstances.
Effective January 1, 2007, the FDIC adopted final regulations pursuant to the above legislation to more closely tie each financial institution’s deposit insurance premiums to the risk each institution poses to the Deposit Insurance Fund. Under the new regulations, the FDIC evaluates the risk of each financial institution based on its supervisory rating, financial ratios, and long-term debt issuer rating. The current rates under the new regulations for nearly all insured financial institutions vary between five and seven cents per $100 of assessable deposits. The FDIC allows credits based on certain assessments previously paid, and the Bank believes that it has such credits that will offset certain future assessments.
In addition, banks must continue to pay an amount toward the retirement of the Financing Corporation bonds issued in the 1980’s to assist in the recovery of the savings and loan industry. This amount fluctuates, but for the first quarter of 2007 is 1.22 cents per $100 of insured deposits. These assessments will continue until the Financing Corporation bonds mature in 2017 through 2019.
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Community Reinvestment Act
The Bank is subject to certain requirements and reporting obligations under the Community Reinvestment Act (“CRA”). The CRA generally requires federal banking agencies to evaluate the record of a financial institution in meeting the credit needs of its local communities, including low and moderate income neighborhoods. The CRA further requires the agencies to consider a financial institution’s efforts in meeting its community credit needs when evaluating applications for, among other things, domestic branches, consummating mergers or acquisitions, or holding company formations. In measuring a bank’s compliance with its CRA obligations, the regulators utilize a performance-based evaluation system. They determine CRA ratings based on the bank’s actual lending, service, and investment activities, rather than on the extent to which the institution conducts needs assessments, documents community outreach activities or complies with other procedural requirements. In connection with its assessment of CRA performance, the FDIC assigns a rating of “outstanding,” “satisfactory,” “needs to improve” or “substantial noncompliance.” The Bank was last examined for CRA compliance in July 2004 when it received a “satisfactory” Assessment Rating.
Other Consumer Protection Laws and Regulations
The bank regulatory agencies are increasingly focusing attention on compliance with consumer protection laws and regulations. Examination and enforcement has become intense, and banks have been advised to carefully monitor compliance with various consumer protection laws and regulations. The federal Interagency Task Force on Fair Lending issued a policy statement on discrimination in home mortgage lending describing three methods that federal agencies will use to prove discrimination: overt evidence of discrimination, evidence of disparate treatment, and evidence of disparate impact. In addition to CRA and fair lending requirements, the Bank is subject to numerous other federal consumer protection statutes and regulations. Due to heightened regulatory concern related to compliance with consumer protection laws and regulations generally, the Bank may incur additional compliance costs or be required to expend additional funds for investments in the local communities it serves.
Interstate Banking and Branching
The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 (the “Interstate Banking Act”) regulates the interstate activities of banks and bank holding companies and establishes a framework for nationwide interstate banking and branching. Since June 1, 1997, a bank has generally been permitted to merge with a bank in another state without the need for explicit state law authorization. However, states were given the ability to prohibit interstate mergers with banks in their own state by “opting-out” (enacting state legislation applying equality to all out-of-state banks prohibiting such mergers) prior to June 1, 1997.
Since 1995, adequately capitalized and managed bank holding companies have been permitted to acquire banks located in any state, subject to two exceptions: first, any state may still prohibit bank holding companies from acquiring a bank which is less than five years old; and second, no interstate acquisition can be consummated by a bank holding company if the acquirer would control more than 10% of the deposits held by insured depository institutions nationwide or 30% percent or more of the deposits held by insured depository institutions in any state in which the target bank has branches. A bank may establish and operate de novo branches in any state in which the bank does not already maintain a branch if that state has enacted legislation to expressly permit all out-of-state banks to establish branches in that state.
In 1995 California enacted legislation to implement important provisions of the Interstate Banking Act discussed above and to repeal California’s previous interstate banking laws, which were largely preempted by the Interstate Banking Act.
The changes effected by Interstate Banking Act and California laws have increased competition in the environment in which the Bank operates to the extent that out-of-state financial institutions directly or indirectly enter the Bank’s market areas. It appears that the Interstate Banking Act has contributed to accelerated consolidation within the banking industry.
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Financial Modernization Act
Effective March 11, 2000, the Gramm-Leach-Bliley Act (also known as the “Financial Modernization Act”) enabled full affiliations to occur between banks and securities firms, insurance companies, and other financial service providers. This legislation permits bank holding companies to become “financial holding companies” and thereby acquire securities firms and insurance companies and engage in other activities that are financial in nature. A bank holding company may become a financial holding company if each of its subsidiary banks is “well capitalized” and “well managed” under applicable definitions, and has at least a satisfactory rating under the CRA, by filing a declaration that the bank holding company wishes to become a financial holding company. No regulatory approval will be required for a financial holding company to acquire a company, other than a bank or savings association, engaged in activities that are financial in nature or incidental to activities that are financial in nature, as determined by the Federal Reserve Board. The Company has no current intention of becoming a financial holding company, but may do at some point in the future if deemed appropriate in view of opportunities or circumstances at the time.
The Financial Modernization Act defines “financial in nature” to include securities underwriting, dealing and market making; sponsoring mutual funds and investment companies; insurance underwriting and agency; merchant banking activities; and activities that the Board has determined to be closely related to banking. A national bank (and therefore, a state bank as well) may also engage, subject to limitations on investment, in activities that are financial in nature, other than insurance underwriting, insurance company portfolio investment, real estate development and real estate investment, through a financial subsidiary of the bank, if the bank is well capitalized, well managed and has at least a satisfactory CRA rating. Subsidiary banks of a financial holding company or national banks with financial subsidiaries must continue to be well capitalized and well managed in order to continue to engage in activities that are financial in nature without regulatory actions or restrictions, which could include divestiture of financial subsidiaries. In addition, a financial holding company or a bank may not acquire a company that is engaged in activities that are financial in nature unless each of the subsidiary banks of the financial holding company or the bank has a CRA rating of satisfactory or better.
The Financial Modernization Act also imposes extensive requirements on financial institutions with respect to the privacy of customer information, and modifies other existing laws, including those related to community reinvestment.
USA Patriot Act of 2001
The USA Patriot Act of 2001 (the “Patriot Act”) was enacted in October 2001 in response to the terrorist attacks in New York, Pennsylvania and Washington, D.C. on September 11, 2001. The Patriot Act was designed to strengthen the ability of U.S. law enforcement agencies and intelligence communities to work cohesively to combat terrorism on a variety of fronts. The impact of the Patriot Act on financial institutions of all kinds has been significant and wide ranging. The Patriot Act substantially enhanced existing anti-money laundering and financial transparency laws, and required appropriate regulatory authorities to adopt rules to promote cooperation among financial institutions, regulators, and law enforcement entities in identifying parties that may be involved in terrorism or money laundering. Under the Patriot Act, financial institutions are subject to prohibitions regarding specified financial transactions and account relationships, as well as enhanced due diligence and “know your customer” standards in their dealings with foreign financial institutions and foreign customers. For example, the enhanced due diligence policies, procedures, and controls generally require financial institutions to take reasonable steps to:
| • | conduct enhanced scrutiny of account relationships to guard against money laundering and report any suspicious transactions; |
| • | ascertain the identity of the nominal and beneficial owners of, and the source of funds deposited into, each account as needed to guard against money laundering and report any suspicious transactions; |
| • | ascertain for any foreign bank, the shares of which are not publicly traded, the identity of the owners of the foreign bank, and the nature and extent of the ownership interest of each such owner; and |
| • | ascertain whether any foreign bank provides correspondent accounts to other foreign banks and, if so, the identity of those foreign banks and related due diligence information. |
The Patriot Act also requires all financial institutions to establish anti money laundering programs, which must include, at minimum:
| • | the development of internal policies, procedures, and controls; |
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| • | the designation of a compliance officer; |
| • | an ongoing employee training program; and |
| • | an independent audit function to test the programs. |
The Company has incorporated the requirements of the Patriot Act into its operating procedures, and while these requirements have resulted in an additional time burden, the financial impact on the Company is difficult to quantify.
Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) was enacted to increase corporate responsibility, provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and protect investors by improving the accuracy and reliability of disclosures pursuant to the securities laws. Sarbanes-Oxley includes important new requirements for public companies in the areas of financial disclosure, corporate governance, and the independence, composition and responsibilities of audit committees. Among other things, Sarbanes-Oxley mandates chief executive and chief financial officer certifications of periodic financial reports, additional financial disclosures concerning off-balance sheet items, and speedier transaction reporting requirements for executive officers, directors and 10% shareholders. In addition, penalties for non-compliance with the Exchange Act were heightened. SEC rules promulgated pursuant to Sarbanes-Oxley impose obligations and restrictions on auditors and audit committees intended to enhance their independence from management, and include extensive additional disclosure, corporate governance and other related rules. Sarbanes-Oxley represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.
The Company has not experienced any significant difficulties in complying with Sarbanes-Oxley. However, the Company has incurred, and expects to continue to incur, significant time and expense in connection with its compliance with Section 404 of Sarbanes-Oxley (“SOX 404”), which requires management to undertake an annual assessment of the adequacy and effectiveness of the Company’s internal controls over financial reporting and requires the Company’s auditors to attest to, and report on, management’s assessment and the operating effectiveness of these controls. Not including one full-time staff position dedicated exclusively to SOX 404 and other internal staff time, the amount ultimately expended by the Company specifically for compliance with SOX 404 for 2004, the first year in which we were subject to this regulation, totaled over $400,000. Again not including internal salaries and benefits, SOX 404 compliance expenses related to 2006 and 2005 were approximately $170,000 and $260,000, respectively.
Other Pending and Proposed Legislation
Other legislative and regulatory initiatives which could affect the Company, the Bank and the banking industry in general are pending, and additional initiatives may be proposed or introduced before the United States Congress, the California legislature and other governmental bodies in the future. Such proposals, if enacted, may further alter the structure, regulation and competitive relationship among financial institutions, and may subject the Bank to increased regulation, disclosure and reporting requirements. In addition, the various banking regulatory agencies often adopt new rules and regulations to implement and enforce existing legislation. It cannot be predicted whether, or in what form, any such legislation or regulations may be enacted or the extent to which the business of the Company or the Bank would be affected thereby.
| ITEM 1A. | RISK FACTORS |
Statements and financial discussion and analysis by management contained throughout this report that are not historical facts are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve a number of risks and uncertainties. Factors that could cause actual results to differ materially from forward-looking statements herein include, without limitation, the factors set forth below.
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Poor economic conditions in our market areas may cause us to suffer higher default rates on our loans and leases. A substantial majority of our assets and deposits are generated in the San Joaquin Valley in central California. As a result, poor economic conditions in this region could cause us to incur losses associated with higher default rates and decreased collateral values in our loan portfolio. The local economy currently appears to be experiencing a moderate expansion, and while the Company expects continued improvement, no assurance can be given that this will occur.
Some areas in the south and central San Joaquin Valley have experienced substantial commercial growth in recent years, for a number of reasons. The area’s relatively inexpensive real estate and central proximity to both Southern and Northern California have attracted a growing number of warehouse and distribution facilities, as well as manufacturing, health, and other service companies. The low cost of housing has also drawn retirees from more expensive areas of California. Despite the economic growth that has occurred, unemployment levels are still relatively high in the San Joaquin Valley. In the Visalia-Tulare-Porterville Metropolitan Statistical Area (“MSA”), for example, which is our geographic center and the base of our agriculturally oriented communities, the unemployment rate was 9.2% in December 2006, double the 4.6% aggregate unemployment rate for California for the same month. The unemployment rate for Visalia-Tulare-Porterville has been improving, however, dropping to an average of 9% for 2005 and 2006 from almost 12% for 2001 through 2004, and nearly 16% for 1990 through 2000.
Poor economic conditions affecting the agricultural industry could have an adverse effect on our customers and their ability to make payments to us. While currently at relatively low levels, the Company’s balance of non-performing assets has been comparatively high in past years due in large part to persistent agricultural difficulties. Furthermore, a sizable portion of our total loan portfolio consists of loans to borrowers either directly or indirectly involved in the agricultural industry. While a great number of our borrowers may not be individually involved in agriculture, many of the jobs in the San Joaquin Valley are ancillary to the regular production, processing, marketing and sales of agricultural commodities.
Weather patterns in particular are of critical importance to row crop, tree fruit, and orange production, and global competition is another significant issue affecting the agricultural industry. Because of increased global competition and other factors, excess supply and low prices currently characterize the markets for many agricultural products. The ripple effect of lower commodity prices for milk, nuts, olives, grapes, oranges and tree fruit has a tendency to depress land prices, lower borrower income, and decrease collateral values. A degenerative cycle of weather and commodity prices can also impact consumer purchasing power, which has the potential to create further unemployment throughout the San Joaquin Valley. By way of example, the recent freeze in the San Joaquin Valley destroyed much of the orange crop as well as various other goods. Many large growers, packing houses, and transportation companies carry insurance to help offset the detrimental impact of the freeze, and are able to continue operations with minimal financial disruption. Many small-acreage farmers, however, do not have insurance coverage and now face severe economic difficulties. Likewise, the laborers involved in picking and packing typically do not have backup resources when employment prospects disappear, and are forced to rely on donations and government assistance rather than patronize the retail outlets that they otherwise might. While the recent freeze in and of itself has not yet had a noticeable impact on our operations, if general agricultural conditions do not improve, our level of non-performing assets could increase. Such conditions have affected and may continue to adversely affect our borrowers and, by extension, our business.
Concentrations of real estate loans could subject us to increased risks in the event of a real estate recession or natural disaster. Our loan portfolio is heavily concentrated in real estate loans, particularly commercial real estate. At December 31, 2006, 73% of our loan portfolio consisted of loans secured by real estate. In the early 1990’s, the entire state of California experienced an economic recession that particularly impacted real estate values and resulted in increases in the level of delinquencies and losses for many financial institutions. In past decades, much of our market area seems to have been insulated from the significant fluctuations in real estate prices experienced by other parts of California. However, during the last few years real estate values in our market areas have escalated at least as rapidly as in other parts of the state, and the collateral for many of our loans could be reduced in value and the ability of some of our borrowers to pay could decline if a real estate recession affects our market areas in the future. Similarly, the occurrence of a natural disaster like those California has experienced in the past, including earthquakes, brush fires, and flooding, could impair the value of the collateral we hold for real estate secured loans and negatively impact our results of operations.
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We may have difficulty managing our growth. Management intends to leverage the Company’s current infrastructure to grow assets, and the addition of new branches has been tentatively planned, although no assurance can be given that this strategy will result in significant growth. Our ability to manage growth will depend primarily on our ability to:
| • | monitor and manage expanded operations; |
| • | control funding costs and operating expenses; |
| • | maintain positive customer relations; and |
| • | attract, assimilate and retain qualified personnel. |
If we fail to achieve these objectives in an efficient and timely manner we may experience disruptions in our business plans, and our financial condition and results of operations could be adversely affected.
Interest rate fluctuations and other economic conditions which are beyond our control could negatively impact our profitability. The earnings of most financial institutions depend largely on the relationship between the cost of funds, primarily deposits and borrowings, and the yield on earning assets such as loans and investment securities. This relationship, known as the interest rate spread, is subject to fluctuation and is affected by economic, regulatory and competitive factors that influence interest rates, the volume and mix of interest-earning assets and interest-bearing liabilities, and the level of non-performing assets. Many of these factors are beyond our control. Fluctuations in interest rates affect the demand of customers for our products and services, and the Company is subject to interest rate risk to the degree that our interest-bearing liabilities re-price or mature more slowly or more rapidly or on a different basis than our interest-earning assets. Given the current volume, mix, and re-pricing characteristics of the Company’s interest-bearing liabilities and interest-earning assets, our interest rate spread is expected to increase slightly in a rising rate environment, and decrease slightly in a declining interest rate scenario. However, there are scenarios where fluctuations in interest rates in either direction could have a negative effect on net income. For example, if funding rates rise faster than asset yields in a rising rate environment (i.e., if basis compression occurs), or if we do not actively manage certain loan index rates in a declining rate environment, we would be negatively impacted.
We operate in a competitive market dominated by banks and other financial services providers, many of which have lower cost structures and offer more services, and our efforts to compete may not be successful. In California generally, and in our primary service area specifically, branches of major banks dominate the commercial banking industry. By virtue of their larger capital base, such institutions have substantially greater lending limits than we do, and perform certain functions for their customers, including trust services and international banking, which we are not equipped to offer directly (but some of which we offer indirectly through correspondent relationships). Many of these banks also operate with economies of scale that result in lower operating costs relative to revenue generated.
We also compete with other financial institutions such as savings and loan associations, credit unions, thrift and loan companies, mortgage companies, securities brokerage companies and insurance companies, and with quasi-financial institutions such as money market funds, for deposits and loans. Financial services like ours are increasingly offered over the Internet on a national and international basis, and we compete with providers of these services as well. Ultimately, competition can drive down our interest margins and reduce our profitability. It can also make it more difficult for us to continue to increase the size of our loan and deposit portfolios.
You may not be able to sell your shares at the times and in the amounts you want if a more active trading market for our stock does not develop. Although our stock has been listed on NASDAQ for many years, trading in our stock has not been extensive and cannot be characterized as amounting to an active trading market.
We may experience loan and lease losses in excess of our allowance for loan and lease losses. We are careful in our loan underwriting process in order to limit the risk that borrowers might fail to repay; nevertheless, losses can and do occur. We create an allowance for estimated loan and lease losses in our accounting records, based on estimates of the following:
| • | industry standards; |
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| • | historical experience with our loans; |
| • | evaluation of economic conditions; |
| • | regular reviews of the quality mix and size of the overall loan portfolio; |
| • | regular reviews of delinquencies; and |
| • | the quality of the collateral underlying our loans. |
We maintain an allowance for loan and lease losses at a level that we believe is adequate to absorb any specifically identified losses as well as any other losses inherent in our loan portfolio. However, changes in economic, operating and other conditions, including changes in interest rates, that are beyond our control, may cause our actual loan losses to exceed our current allowance estimates. If actual losses exceed the amount reserved, it will have a negative impact on our profitability. In addition, the FDIC and the DFI, as part of their supervisory functions, periodically review our allowance for loan and lease losses. Such agencies may require us to increase our provision for loan and lease losses or to recognize further losses, based on their judgments, which may be different from those of our management. Any increase in the allowance required by the FDIC or the DFI could also hurt our business.
Provisions in our articles of incorporation will delay or prevent changes in control of our corporation or our management. These provisions make it more difficult for another company to acquire us, which could reduce the market price of our common stock and the price that you receive if you sell your shares in the future. These provisions include the following:
| • | staggered terms of office for members of the board of directors; |
| • | the elimination of cumulative voting in the election of directors; and |
| • | the requirement that our Board of Directors consider the potential social and economic effects on our employees, depositors, customers and the communities we serve as well as certain other factors, when evaluating a possible tender offer, merger or other acquisition of the Company. |
| ITEM 1B. | UNRESOLVED STAFF COMMENTS |
Not applicable.
| ITEM 2. | PROPERTIES |
The Company’s administrative headquarters is located at 86 North Main Street, Porterville, California, and is leased through April 2014 from parties unrelated to the Company. It consists of approximately 37,000 square feet in a three-story building of which the Company is sole occupant, and the rent as of December 31, 2006 was $12,082 per month. The Company’s main office is adjacent to its administrative headquarters, at 90 N. Main Street, Porterville, California, and consists of a one-story brick building that sits upon unencumbered property owned by the Company. The Company also owns unencumbered property on which 12 of its 19 other branches are located, including the branches in Lindsay, Exeter, Three Rivers, Dinuba, Tulare, Hanford, Tehachapi, and California City. One of the Fresno branches is owned while the other is leased from unrelated parties, while two of the three branches in Bakersfield are leased from unrelated parties. Both Visalia branches and the Clovis branch are leased from unrelated parties. In addition, the Company operates a technology center in Porterville which consists of approximately 12,000 square feet in a freestanding single-story building that is leased from unrelated parties. The Bank has six remote ATM locations leased from unrelated parties, although the amount of monthly rent at these locations is minimal. Management believes that the Company’s existing back office facilities are adequate to accommodate the Company’s operations for the immediately foreseeable future, although limited branch expansion is planned.
| ITEM 3. | LEGAL PROCEEDINGS |
From time to time, the Company is a party to claims and legal proceedings arising in the ordinary course of business. After taking into consideration information furnished by counsel to the Company as to the current status of these claims or proceedings to which the Company is a party, management is of the opinion that the ultimate aggregate liability represented thereby, if any, will not have a material adverse affect on the financial condition of the Company.
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| ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS |
Not applicable.
| ITEM 5. | MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |
| (a) | Market Information |
Sierra Bancorp’s Common Stock trades on the NASDAQ Global Select Market under the symbol BSRR, and the CUSIP number for our stock is #82620P102. Trading in the Common Stock of the Company has not been extensive and such trades cannot be characterized as amounting to an active trading market. Management is aware of the following securities dealers which make a market in the Company’s stock: B-Trade Services LLC, New York; Citadel Derivatives Group LLC, Chicago; Citigroup Global Markets, New York; Goldman, Sachs & Co., New York; Howe Barnes Hoefer & Arnett, Inc., San Francisco; Keefe, Bruyette & Woods, New York; Knight Securities, Jersey City; Lehman Brothers Inc., New York; Monroe Securities, Chicago; Morgan Stanley, New York; Sandler O’Neill, New York; and UBS Capital Markets, Jersey City. The following table summarizes trades of the Company’s Common Stock, setting forth the approximate high and low sales prices and volume of trading for the periods indicated, based upon information provided by public sources.
| Sale Price of the Company’s Common Stock (per share) |
Approximate Trading Volume In Shares | |||||||
| Calendar Quarter Ended |
High | Low | ||||||
| March 31, 2005 |
$ | 24.25 | $ | 21.55 | 453,057 | |||
| June 30, 2005 |
$ | 24.50 | $ | 19.00 | 871,271 | |||
| September 30, 2005 |
$ | 24.99 | $ | 21.40 | 688,507 | |||
| December 31, 2005 |
$ | 24.56 | $ | 21.75 | 551,949 | |||
| March 31, 2006 |
$ | 26.50 | $ | 22.16 | 358,168 | |||
| June 30, 2006 |
$ | 28.50 | $ | 23.41 | 723,417 | |||
| September 30, 2006 |
$ | 33.37 | $ | 25.55 | 1,102,252 | |||
| December 31, 2006 |
$ | 35.36 | $ | 29.01 | 1,136,008 | |||
| (b) | Holders |
On February 28, 2007 there were approximately 2,109 shareholders of the Company’s Common Stock. Per the Company’s stock transfer agent, on that date there were 658 registered holders of record and an additional 1,451 beneficial holders whose shares are held under a street name.
| (c) | Dividends |
As a bank holding company that currently has no significant assets other than its equity interest in the Bank, the Company’s ability to declare dividends depends primarily upon dividends it receives from the Bank. The Bank’s dividend practices in turn depend upon legal restrictions, the Bank’s earnings, financial position, current and anticipated capital requirements, and other factors deemed relevant by the Bank’s Board of Directors at that time.
The Company paid cash dividends totaling $5.3 million, or $0.54 per share in 2006, and $4.4 million, or $0.45 per share in 2005, representing 33% of prior year earnings for dividends paid in both years. The Company’s general dividend policy is to pay cash dividends within the range of typical peer payout ratios, provided that such payments do not adversely affect the Company’s financial condition and are not overly restrictive to its growth capacity. However, no assurance can be given that earnings and/or growth expectations in any given year will justify the payment of such a dividend.
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During any period in which the Company has deferred payment of interest otherwise due and payable on its subordinated debt securities, it may not make any dividends or distributions with respect to its capital stock (see “Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations – Capital Resources”). The power of the Bank’s Board of Directors to declare cash dividends is also subject to statutory and regulatory restrictions which limit the amount available for cash dividends depending upon the earnings, financial condition and cash needs of the Bank, as well as general business conditions. Under California banking law, the Bank may declare dividends in an amount not exceeding the lesser of its retained earnings or its net income for the last three years (reduced by dividends paid during such period) or, with the prior approval of the California Commissioner of Financial Institutions, in an amount not exceeding the greatest of (i) the retained earnings of the Bank, (ii) the net income of the Bank for its last fiscal year, or (iii) the net income of the Bank for its current fiscal year. The payment of any cash dividends by the Bank will depend not only upon the Bank’s earnings during a specified period, but also on the Bank meeting certain regulatory capital requirements.
The Company’s ability to pay dividends is also limited by state corporation law. The California General Corporation Law allows a California corporation to pay dividends if the company’s retained earnings equal at least the amount of the proposed dividend. If a California corporation does not have sufficient retained earnings available for the proposed dividend, it may still pay a dividend to its shareholders if it meets two conditions immediately after giving effect to the dividend, but it is extremely unlikely that those conditions would ever be met by the Company.
| (d) | Securities Authorized for Issuance under Equity Compensation Plans |
The following table provides information as of December 31, 2006, with respect to options outstanding and available under our 1998 Stock Option Plan, which at that time was our only equity compensation plan other than an employee benefit plan meeting the qualification requirements of Section 401(a) of the Internal Revenue Code:
| Plan Category |
Number of Securities to be Issued Upon Exercise
of |
Weighted-Average of Outstanding Options |
Number of Securities for Future Issuance | ||||
| Equity compensation plans approved by security holders |
937,367 | $ | 12.17 | 579,164 | |||
| (e) | Performance Graph |
The following is a performance graph comparing the total cumulative shareholder return on the Company’s common stock since December 31, 2001 to the cumulative total returns of the NASDAQ Composite Index (a broad equity market index), the SNL Bank Index, and the SNL $1 billion to $5 billion (asset size) Bank Index (the latter two qualifying as peer bank indices), assuming a $100 investment on December 31, 2001 and the reinvestment of dividends:
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| Period Ending | ||||||||||||
| Index |
12/31/01 | 12/31/02 | 12/31/03 | 12/31/04 | 12/31/05 | 12/31/06 | ||||||
| Sierra Bancorp |
100.00 | 148.23 | 236.21 | 351.91 | 357.83 | 469.66 | ||||||
| NASDAQ Composite |
100.00 | 69.13 | 103.36 | 112.49 | 114.88 | 126.22 | ||||||
| SNL $1B-$5B Bank Index |
100.00 | 115.44 | 156.98 | 193.74 | 190.43 | 220.36 | ||||||
| SNL Bank Index |
100.00 | 91.69 | 123.69 | 138.61 | 140.50 | 164.35 | ||||||
| (f) | Stock Repurchases |
The Company has a stock repurchase program that became effective July 1, 2003 and currently has no expiration date. The plan initially allowed for the repurchase of up to 250,000 shares, although that number was supplemented by an additional 250,000 shares by the Company’s Board at its regular meeting in May 2005, and another 250,000 shares at the regular Board meeting held in March 2006. The following table provides information concerning the Company’s repurchases of its Common Stock during the fourth quarter of 2006, which were all executed in accordance with SEC Rule 10b-18:
| October | November | December | ||||||
| Total shares purchased |
None | 109,000 | 17,800 | |||||
| Average per share price |
N/A | $ | 31.19 | $ | 31.29 | |||
| Number of shares purchased as part of publicly announced plan or program |
None | 109,000 | 17,800 | |||||
| Maximum number of shares remaining for purchase under a plan or program |
226,800 | 117,800 | 100,000 | |||||
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| ITEM 6. | SELECTED FINANCIAL DATA |
The following table presents selected historical financial information concerning the Company, which should be read in conjunction with our audited consolidated financial statements, including the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” included elsewhere herein. The selected financial data as of December 31, 2006 and 2005, and for each of the years in the three year period ended December 31, 2006, is derived from our audited consolidated financial statements and related notes which are included in this Annual Report. The selected financial data for prior years is derived from our audited financial statements which are not included in this Annual Report. Throughout this Annual Report, information is for the consolidated Company unless otherwise stated.
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Selected Financial Data
As of and for the years ended December 31,
(Dollars in thousands, except per share data)
| 2006 | 2005 | 2004 | 2003 | 2002 | ||||||||||||||||
| Income Statement Summary |
||||||||||||||||||||
| Interest income |
$ | 80,778 | $ | 64,135 | $ | 52,008 | $ | 42,607 | $ | 42,085 | ||||||||||
| Interest expense |
$ | 25,131 | $ | 13,332 | $ | 8,496 | $ | 6,874 | $ | 9,096 | ||||||||||
| Net interest income before provision for loan losses |
$ | 55,647 | $ | 50,803 | $ | 43,512 | $ | 35,733 | $ | 32,989 | ||||||||||
| Provision for loan losses |
$ | 3,851 | $ | 3,150 | $ | 3,473 | $ | 3,105 | $ | 3,350 | ||||||||||
| Non interest income |
$ | 11,212 | $ | 9,258 | $ | 9,792 | $ | 9,862 | $ | 8,522 | ||||||||||
| Non-interest expense |
$ | 33,841 | $ | 32,634 | $ | 29,311 | $ | 27,743 | $ | 26,242 | ||||||||||
| Income before provision for income taxes |
$ | 29,167 | $ | 24,277 | $ | 20,520 | $ | 14,747 | $ | 11,919 | ||||||||||
| Provision for income taxes |
$ | 9,977 | $ | 8,083 | $ | 7,174 | $ | 4,383 | $ | 3,080 | ||||||||||
| Net Income |
$ | 19,190 | $ | 16,194 | $ | 13,346 | $ | 10,364 | $ | 8,839 | ||||||||||
| Balance Sheet Summary |
||||||||||||||||||||
| Total loans, net |
$ | 872,811 | $ | 729,780 | $ | 686,157 | $ | 602,264 | $ | 505,655 | ||||||||||
| Allowance for loan losses |
$ | (11,579 | ) | $ | (9,930 | ) | $ | (8,842 | ) | $ | (6,701 | ) | $ | (5,939 | ) | |||||
| Securities available for sale |
$ | 190,272 | $ | 193,676 | $ | 198,024 | $ | 84,798 | $ | 83,911 | ||||||||||
| Cash and due from banks |
$ | 52,725 | $ | 50,147 | $ | 36,735 | $ | 53,042 | $ | 55,819 | ||||||||||
| Federal funds sold |
$ | 6,290 | $ | — | $ | — | $ | — | $ | — | ||||||||||
| Other real estate owned |
$ | — | $ | 533 | $ | 2,524 | $ | 2,784 | $ | 1,421 | ||||||||||
| Premises and equipment, net |
$ | 17,978 | $ | 18,055 | $ | 17,731 | $ | 18,291 | $ | 17,578 | ||||||||||
| Total Interest-Earning assets |
$ | 1,084,650 | $ | 935,381 | $ | 894,835 | $ | 696,255 | $ | 596,529 | ||||||||||
| Total Assets |
$ | 1,215,074 | $ | 1,052,686 | $ | 997,483 | $ | 801,674 | $ | 701,578 | ||||||||||
| Total Interest-Bearing liabilities |
$ | 827,752 | $ | 678,009 | $ | 680,886 | $ | 536,811 | $ | 475,716 | ||||||||||
| Total Deposits |
$ | 868,445 | $ | 815,671 | $ | 742,703 | $ | 684,477 | $ | 605,705 | ||||||||||
| Total Liabilities |
$ | 1,124,703 | $ | 973,923 | $ | 926,348 | $ | 741,698 | $ | 648,291 | ||||||||||
| Total Shareholders’ Equity |
$ | 90,371 | $ | 78,763 | $ | 71,135 | $ | 59,976 | $ | 53,287 | ||||||||||
| Per Share Data |
||||||||||||||||||||
| Net Income Per Basic Share |
$ | 1.96 | $ | 1.66 | $ | 1.41 | $ | 1.12 | $ | 0.96 | ||||||||||
| Net Income Per Diluted Share |
$ | 1.87 | $ | 1.56 | $ | 1.31 | $ | 1.03 | $ | 0.91 | ||||||||||
| Book Value |
$ | 9.27 | $ | 8.10 | $ | 7.37 | $ | 6.43 | $ | 5.78 | ||||||||||
| Cash Dividends |
$ | 0.54 | $ | 0.45 | $ | 0.37 | $ | 0.36 | $ | 0.28 | ||||||||||
| Weighted Average Common Shares Outstanding Basic |
9,766,729 | 9,763,896 | 9,482,201 | 9,288,908 | 9,252,093 | |||||||||||||||
| Weighted Average Common Shares Outstanding Diluted |
10,273,859 | 10,357,795 | 10,166,302 | 10,018,096 | 9,665,839 | |||||||||||||||
| Key Operating Ratios: |
||||||||||||||||||||
| Performance Ratios: |
||||||||||||||||||||
| Return on Average Equity (1) |
22.75 | % | 21.47 | % | 20.50 | % | 18.34 | % | 17.59 | % | ||||||||||
| Return on Average Assets (2) |
1.70 | % | 1.59 | % | 1.47 | % | 1.43 | % | 1.32 | % | ||||||||||
| Net Interest Spread (tax-equivalent) (3) |
4.75 | % | 5.11 | % | 5.17 | % | 5.38 | % | 5.22 | % | ||||||||||
| Net Interest Margin (tax-equivalent) |
5.58 | % | 5.64 | % | 5.49 | % | 5.71 | % | 5.64 | % | ||||||||||
| Dividend Payout Ratio (4) |
27.53 | % | 27.18 | % | 26.27 | % | 32.27 | % | 29.31 | % | ||||||||||
| Equity to Assets Ratio (5) |
7.46 | % | 7.40 | % | 7.19 | % | 7.77 | % | 7.50 | % | ||||||||||
| Efficiency Ratio (tax-equivalent) |
49.63 | % | 52.64 | % | 54.04 | % | 59.66 | % | 61.60 | % | ||||||||||
| Net Loans to Total Deposits at Period End |
100.50 | % | 89.47 | % | 92.39 | % | 87.99 | % | 83.48 | % | ||||||||||
| Asset Quality Ratios: |
||||||||||||||||||||
| Non Performing Loans to Total Loans |
0.08 | % | 0.04 | % | 0.35 | % | 1.09 | % | 1.26 | % | ||||||||||
| Nonperforming Assets to Total Loans and Other Real Estate Owned |
0.08 | % | 0.11 | % | 0.71 | % | 1.54 | % | 1.53 | % | ||||||||||
| Net Charge-offs (recoveries) to Average Loans |
0.19 | % | 0.38 | % | 0.21 | % | 0.43 | % | 0.62 | % | ||||||||||
| Allowance for Loan Losses to Net Loans at Period End |
1.33 | % | 1.36 | % | 1.29 | % | 1.11 | % | 1.17 | % | ||||||||||
| Allowance for Loan Losses to Non-Performing Loans |
1680.55 | % | 3213.59 | % | 361.19 | % | 100.27 | % | 91.84 | % | ||||||||||
| Capital Ratios: |
||||||||||||||||||||
| Tier 1 Capital to Adjusted Total Assets |
9.92 | % | 9.87 | % | 9.20 | % | 8.87 | % | 8.99 | % | ||||||||||
| Tier 1 Capital to Total Risk-weighted Assets |
11.77 | % | 12.01 | % | 11.34 | % | 9.90 | % | 10.91 | % | ||||||||||
| Total Capital to Total Risk-weighted Assets |
12.98 | % | 13.50 | % | 13.30 | % | 10.88 | % | 11.98 | % | ||||||||||
| (1) | Net income divided by average shareholders’ equity. |
| (2) | Net income divided by average total assets. |
| (3) | Represents the average rate earned on interest-earning assets less the average rate paid on interest-bearing liabilities. |
| (4) | Dividends declared per share divided by net income per share. |
| (5) | Average equity divided by average total assets. |
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| ITEM 7. | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
This discussion presents Management’s analysis of the financial condition of the Company as of December 31, 2006 and December 31, 2005, and the results of operations for each of the years in the three-year period ended December 31, 2006. The discussion should be read in conjunction with the Consolidated Financial Statements of the Company and the Notes related thereto presented elsewhere in this Form 10-K Annual Report (see Item 8 below).
Statements contained in this report or incorporated by reference that are not purely historical are forward looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 as amended, including the Company’s expectations, intentions, beliefs, or strategies regarding the future. All forward-looking statements concerning economic conditions, growth rates, income, expenses, or other values as may be included in this document are based on information available to the Company on the date noted, and the Company assumes no obligation to update any such forward-looking statements. It is important to note that the Company’s actual results could materially differ from those in such forward-looking statements. Risk factors that could cause actual results to differ materially from those in forward-looking statements include but are not limited to those outlined previously in Item 1A.
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 various other assumptions that are believed to be reasonable under current circumstances. Actual results may differ from those estimates under different 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 losses, as explained in detail in the “Provision for Loan Losses” and “Allowance for Loan Losses” sections of this discussion and analysis; loan origination costs, which are deferred from current expense and amortized over the life of the loans, are estimated based on an annual evaluation of expenses (primarily salaries) associated with successful loan originations and are allocated to individual loans as they are booked, but can actually vary significantly for individual loans depending on the characteristics of such loans (deferred amounts are disclosed below in conjunction with salaries expense, under “Non-interest Revenue and Operating Expense”); 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; goodwill, which is evaluated annually based on changes in the market capitalization of the Company and for which management has determined that no impairment exists; and equity-based compensation, which is discussed in greater detail in footnote 2 (Significant Accounting Policies) to the financial statements contained herein, under the caption “Stock-Based Compensation.” 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 these areas.
Summary of Performance
The Company achieved record earnings again in 2006, and has now increased net income in 23 of the last 24 years. Net income in 2006 was $19.2 million, an increase of $3.0 million, or 19%, over the $16.2 million in net earnings achieved in 2005. Net income in 2005 was nearly $2.9 million higher than 2004 net earnings of $13.3 million. Net income per basic share was $1.96 for 2006, as compared to $1.66 during 2005 and $1.41 in 2004. The Company’s Return on Average Assets was 1.70% and Return on Average Equity was 22.75% in 2006, as compared to 1.59% and 21.47%, respectively for 2005, and 1.47% and 20.5%, respectively in 2004.
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The following are major factors impacting the Company’s results of operations in recent years:
| • | Solid growth in net interest income was a major contributor to the increases in net income in both 2006 and 2005. Net interest income grew by $4.8 million, or 10%, in 2006 relative to 2005, and by $7.3 million, or 17%, in 2005 relative to 2004. The increase in both periods was largely driven by growth in average interest-earning assets. Annual average interest-earning assets increased by $103 million, or 11%, in 2006 compared to 2005, and by $109 million, or 13%, in 2005 as compared to 2004. The impact of this growth on net interest income was significantly lower in 2006, because the termination of short-term interest rate increases in mid-2006 had a negative effect on our asset-sensitive balance sheet, and because the growth in 2006 was relatively low-margin growth that was primarily funded by higher-cost wholesale borrowings rather than core deposits. In contrast, the Company’s tax-equivalent net interest margin increased by 15 basis points in 2005 relative to 2004, due in large part to rising short-term interest rates but also because of 5 basis points attributable to an interest recovery. |
| • | The provision for loan losses was $701,000 higher in 2006 than in 2005, representing an increase of 22%, but $323,000 lower in 2005 than in 2004, a decline of 9%. The increase in 2006 is the result of the $147 million increase in gross outstanding loan balances during 2006, as well as an increased allocation for certain classified loans. Despite a $1.3 million increase in net loans charged off in 2005 relative to 2004, the need to provide for loan losses was lower due to a $2.1 million reduction in non-performing loans and overall improved credit quality. |
| • | Non-interest income increased by 21% in 2006 compared to 2005, but declined by 5% in 2005 relative to 2004. When non-recurring items are backed out, the increase in 2006 falls to 15% and the decrease in 2005 is around 4%. Non-recurring items, including such events as the sale of loans and investment securities, are discussed in greater detail in the “Non-interest Revenue and Operating Expense” section below. Positive trends that are likely to impact non-interest income going forward can be seen in returned item and overdraft fees, check card interchange fees, and operating lease income. |
| • | Operating expense increased by 4% in 2006 over 2005, and 11% in 2005 in comparison to 2004. As with non-interest income, there were several non-recurring items impacting the changes in operating expense. Backing out those items the year-over-year increase in 2006 remains 4%, however the 2005 increase drops to 8%. For both years, the largest dollar increase was in salaries and benefits, a category not impacted by non-recurring items. The $1.1 million, or 7%, increase in salaries and benefits in 2006 includes $314,000 in stock option expense for which recognition was not required in previous years. |
The following are additional factors that are key in understanding our current financial condition:
| • | Gross loan and lease balances increased by $147 million, or 20%, in 2006, mainly from $115 million (21%) growth in loans secured by real estate. |
| • | Non-performing assets remained at nominal levels. Non-performing assets were $689,000, or 0.08% of gross loans plus other real estate owned (“OREO”), at the end of 2006, down slightly from $842,000, or 0.11% of gross loans plus OREO, at the end of 2005. The Company’s last remaining OREO was sold in early 2006, and the OREO balance is currently at zero. |
| • | During 2006, total investment security balances declined by $3 million, or 2%. Cash flows from maturing bonds and prepayments on mortgage-backed securities were, for the most part, either invested in longer-duration municipal securities as a hedge for the possibility of declining rates or used to fund loan growth. |
| • | Other assets increased by $14 million, or 26%, in 2006. This increase is primarily the result of an additional $6 million investment in Bank-owned life insurance (“BOLI”) in December 2006, plus a $5 million increase in Federal Home Loan Bank (FHLB) Stock necessitated by our increased level of FHLB borrowings. |
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| • | While total deposits increased by $53 million, or 6%, during 2006, customer deposits ended the year with an increase of just $8 million, or 1%. Most of the growth in total deposits came from a $45 million increase in wholesale-sourced brokered deposits. Non-interest bearing deposits declined by about 1% in 2006, and fell to 32% of total deposits at the end of 2006 from 35% at the end of 2005. NOW and savings accounts also experienced runoff. Money market deposit accounts increased during the year, capturing some of the demand deposit runoff due to a new higher-interest money market sweep account introduced in 2006, and time deposits under $100,000 also increased. We currently have initiatives in place to grow both consumer and commercial deposits in 2007, although no assurance can be given that deposits will increase as planned. |
| • | Total non-deposit borrowings grew by $96 million in 2006, increasing to 21% of total liabilities at the end of 2006 from 15% at the end of 2005. Since loan growth was significantly greater than growth in deposits, FHLB borrowings were obtained to make up the difference. Our net loans to total deposits ratio increased to 100.5% at the end of 2006 from 89.5% at the end of 2005 due to this increased reliance on wholesale funding. Despite this development, we still have ample sources of liquidity available to fund expected loan growth even if anticipated retail deposit increases don’t materialize. |
| • | In June 2006, the Company issued $15 million in junior subordinated debentures to support the issuance of trust preferred securities by a wholly-owned trust subsidiary. The proceeds from this issuance had the immediate effect of reducing short-term borrowings, but were subsequently used to retire $15 million in higher-cost trust preferred securities when those securities were called in December 2006. |
Results of Operations
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 primarily consists 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 consists 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 was $55.6 million in 2006, compared to $50.8 million in 2005 and $43.5 million in 2004. This represents an increase of 10% in 2006 over 2005, and an increase of 17% in 2005 over 2004. The level of net interest income depends on several factors in combination, including growth in earning assets, yields on earning assets, the cost of interest-bearing liabilities, the relative volumes of earning assets and interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities.
The following Distribution, Rate and Yield table shows, for each of the past three years, the annual average balance for each principal balance sheet category, and the amount of interest income or interest expense associated with that category. This table also shows the yields earned on each component of the Company’s investment and loan portfolio, the average rates paid on each segment of the Company’s interest bearing liabilities, and the Company’s net interest margin.
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| Year Ended December 31, | |||||||||||||||||||||||||||
| 2006(a) | 2005(a) | 2004(a) | |||||||||||||||||||||||||
| Distribution, Rate & Yield (dollars in thousands) |
Average Balance |
Income/ Expense |
Average Rate (b) |
Average Balance |
Income/ Expense |
Average Rate (b) |
Average Balance |
Income/ Expense |
Average Rate (b) |
||||||||||||||||||
| Assets |
|||||||||||||||||||||||||||
| Investments: |
|||||||||||||||||||||||||||
| Federal Funds Sold/Due from Time |
$ | 765 | $ | 34 | 4.44 | % | $ | 4,314 | $ | 136 | 3.15 | % | $ | 4,233 | $ | 54 | 1.28 | % | |||||||||
| Taxable |
$ | 141,747 | $ | 6,294 | 4.44 | % | $ | 164,490 | $ | 6,526 | 3.97 | % | $ | 132,048 | $ | 5,042 | 3.82 | % | |||||||||
| Non-taxable |
$ | 50,941 | $ | 2,040 | 6.16 | % | $ | 37,526 | $ | 1,507 | 6.08 | % | $ | 32,761 | $ | 1,312 | 6.07 | % | |||||||||
| Total Investments |
$ | 193,453 | $ | 8,368 | 4.89 | % | $ | 206,330 | $ | 8,169 | 4.34 | % | $ | 169,042 | $ | 6,408 | 4.19 | % | |||||||||
| Loans and Leases:(c) |
|||||||||||||||||||||||||||
| Agricultural |
$ | 10,950 | $ | 932 | 8.51 | % | $ | 11,257 | $ | 1,471 | 13.07 | % | $ | 11,236 | $ | 735 | 6.54 | % | |||||||||
| Commercial |
$ | 136,946 | $ | 12,886 | 9.41 | % | $ | 123,351 | $ | 9,646 | 7.82 | % | $ | 110,408 | $ | 7,815 | 7.08 | % | |||||||||
| Real Estate |
$ | 600,047 | $ | 51,839 | 8.64 | % | $ | 506,991 | $ | 39,514 | 7.79 | % | $ | 456,567 | $ | 33,015 | 7.23 | % | |||||||||
| Consumer |
$ | 53,790 | $ | 5,115 | 9.51 | % | $ | 50,506 | $ | 4,144 | 8.20 | % | $ | 44,938 | $ | 2,973 | 6.62 | % | |||||||||
| Consumer Credit Cards |
$ | 8,819 | $ | 829 | 9.40 | % | $ | 8,414 | $ | 851 | 10.11 | % | $ | 8,545 | $ | 983 | 11.50 | % | |||||||||
| Direct Financing Leases |
$ | 13,110 | $ | 809 | 6.17 | % | $ | 5,020 | $ | 340 | 6.77 | % | $ | 1,121 | $ | 79 | 7.05 | % | |||||||||
| Other |
$ | 379 | $ | — | 0.00 | % | $ | 2,463 | $ | — | 0.00 | % | $ | 3,783 | $ | — | 0.00 | % | |||||||||
| Total Loans and Leases |
$ | 824,041 | $ | 72,410 | 8.79 | % | $ | 708,002 | $ | 55,966 | 7.90 | % | $ | 636,598 | $ | 45,600 | 7.16 | % | |||||||||
| Total Interest-Earning Assets(e) |
$ | 1,017,494 | $ | 80,778 | 8.05 | % | $ | 914,332 | $ | 64,135 | 7.10 | % | $ | 805,640 | $ | 52,008 | 6.54 | % | |||||||||
| Other Earning Assests |
$ | 7,823 | $ | 6,188 | $ | 5,732 | |||||||||||||||||||||
| Non-Earning Assets |
$ | 105,979 | $ | 98,213 | $ | 94,526 | |||||||||||||||||||||
| Total Assets |
$ | 1,131,296 | $ | 1,018,733 | $ | 905,898 | |||||||||||||||||||||
| Liabilities and Shareholders’ Equity |
|||||||||||||||||||||||||||
| Interest-Bearing Deposits: |
|||||||||||||||||||||||||||
| NOW |
$ | 65,234 | $ | 69 | 0.11 | % | $ | 68,502 | $ | 63 | 0.09 | % | $ | 59,238 | $ | 55 | 0.09 | % | |||||||||
| Savings |
$ | 68,133 | $ | 358 | 0.53 | % | $ | 72,903 | $ | 383 | 0.53 | % | $ | 60,269 | $ | 320 | 0.53 | % | |||||||||
| Money Market |
$ | 125,344 | $ | 2,947 | 2.35 | % | $ | 114,171 | $ | 821 | 0.72 | % | $ | 131,101 | $ | 894 | 0.68 | % | |||||||||
| TDOA’s, and IRA’s |
$ | 23,399 | $ | 780 | 3.33 | % | $ | 22,267 | $ | 481 | 2.16 | % | $ | 22,240 | $ | 360 | 1.62 | % | |||||||||
| Certificates of Deposit < $100,000 |
$ | 96,050 | $ | 3,595 | 3.74 | % | $ | 86,734 | $ | 2,155 | 2.48 | % | $ | 92,535 | $ | 1,499 | 1.62 | % | |||||||||
| Certificates of Deposit > $100,000 |
$ | 182,380 | $ | 8,059 | 4.42 | % | $ | 159,579 | $ | 4,781 | 3.00 | % | $ | 131,212 | $ | 2,283 | 1.74 | % | |||||||||
| Total Interest-Bearing Deposits |
$ | 560,540 | $ | 15,808 | 2.82 | % | $ | 524,156 | $ | 8,684 | 1.66 | % | $ | 496,595 | $ | 5,411 | 1.09 | % | |||||||||
| Borrowed Funds: |
|||||||||||||||||||||||||||
| Federal Funds Purchased |
$ | 13,235 | $ | 675 | 5.10 | % | $ | 690 | $ | 28 | 4.06 | % | $ | 1,003 | $ | 11 | 1.10 | % | |||||||||
| Repurchase Agreements |
$ | 24,281 | $ | 161 | 0.66 | % | $ | 28,772 | $ | 110 | 0.38 | % | $ | 23,782 | $ | 76 | 0.32 | % | |||||||||
| Short Term Borrowings |
$ | 92,106 | $ | 4,307 | 4.68 | % | $ | 25,357 | $ | 824 | 3.25 | % | $ | 18,038 | $ | 284 | 1.57 | % | |||||||||
| Long Term Borrowings |
$ | 32,674 | $ | 975 | 2.98 | % | $ | 60,564 | $ | 1,501 | 2.48 | % | $ | 52,459 | $ | 1,304 | 2.49 | % | |||||||||
| TRUPS |
$ | 38,385 | $ | 3,205 | 8.35 | % | $ | 31,013 | $ | 2,185 | 7.05 | % | $ | 27,717 | $ | 1,410 | 5.09 | % | |||||||||
| Total Borrowed Funds |
$ | 200,681 | $ | 9,323 | 4.65 | % | $ | 146,396 | $ | 4,648 | 3.17 | % | $ | 122,999 | $ | 3,085 | 2.51 | % | |||||||||
| Total Interest Bearing Liabilities |
$ | 761,221 | $ | 25,131 | 3.30 | % | $ | 670,552 | $ | 13,332 | 1.99 | % | $ | 619,594 | $ | 8,496 | 1.37 | % | |||||||||
| Demand Deposits |
$ | 270,183 | $ | 260,661 | $ | 212,321 | |||||||||||||||||||||
| Other Liabilities |
$ | 15,530 | $ | 12,089 | $ | 8,886 | |||||||||||||||||||||
| Shareholders’ Equity |
$ | 84,362 | $ | 75,431 | $ | 65,097 | |||||||||||||||||||||
| Total Liab. and Shareholders’ Equity |
$ | 1,131,296 | $ | 1,018,733 | $ | 905,898 | |||||||||||||||||||||
| Interest Income/Earning Assets |
8.05 | % | 7.10 | % | 6.54 | % | |||||||||||||||||||||
| Interest Expense/Earning Assets |
2.47 | % | 1.46 | % | 1.05 | % | |||||||||||||||||||||
| Net Interest Margin(d) |
$ | 55,647 | 5.58 | % | $ | 50,803 | 5.64 | % | $ | 43,512 | 5.49 | % | |||||||||||||||
| (a) | Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs. |
| (b) | Yields and net interest margin have been computed on a tax equivalent basis. |
| (c) | Loan fees have been included in the calculation of interest income. Loan Fees were approximately $2,395,610, $2,171,360, and $2,290,000 for the years ended December 31, 2006, 2005, and 2004 respectively. Loans are gross of the allowance for possible loan losses. |
| (d) | Represents net interest income as a percentage of average interest-earning assets (tax-equivalent). |
| (e) | Non-accrual loans have been included in total loans for purposes of total interest earning assets. |
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Table of Contents
The Volume and Rate Variances table below sets forth the dollar difference in interest earned and 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 changes in average balances (volume) or changes in average interest rates. Volume variances are equal to the increase or decrease in the average balance times the prior period rate, and rate variances are equal to the increase or decrease in the average rate times the prior period average balance. Variances attributable to both rate and volume changes are equal to the change in rate times the change in average balance.
| Years Ended December 31, | ||||||||||||||||||||||||||||||||
| Volume & Rate Variances (dollars in thousands) |
2006 over 2005 | 2005 over 2004 | ||||||||||||||||||||||||||||||
| Increase (decrease) due to | Increase (decrease) due to | |||||||||||||||||||||||||||||||
| Volume | Rate | Rate/ Vol |
Net | Volume | Rate | Rate/ Vol |
Net | |||||||||||||||||||||||||
| Assets: |
||||||||||||||||||||||||||||||||
| Investments: |
||||||||||||||||||||||||||||||||
| Federal funds sold / Due from time |
$ | (112 | ) | 56 | (46 | ) | $ | (102 | ) | $ | 1 | 79 | 2 | $ | 82 | |||||||||||||||||
| Taxable |
$ | (902 | ) | 778 | (108 | ) | $ | (232 | ) | $ | 1,239 | 197 | 48 | $ | 1,484 | |||||||||||||||||
| Non-taxable(1) |
$ | 539 | (4 | ) | (2 | ) | $ | 533 | $ | 191 | 4 | — | $ | 195 | ||||||||||||||||||
| Total Investments |
$ | (475 | ) | $ | 830 | $ | (156 | ) | $ | 199 | $ | 1,431 | $ | 280 | $ | 50 | $ | 1,761 | ||||||||||||||
| Loans: |
||||||||||||||||||||||||||||||||
| Agricultural |
$ | (40 | ) | (513 | ) | 14 | $ | (539 | ) | $ | 2 | 733 | 1 | $ | 736 | |||||||||||||||||
| Commercial |
$ | 1,063 | 1,961 | 216 | $ | 3,240 | $ | 916 | 819 | 96 | $ | 1,831 | ||||||||||||||||||||
| Real Estate |
$ | 7,253 | 4,286 | 786 | $ | 12,325 | $ | 3,646 | 2,569 | 284 | $ | 6,499 | ||||||||||||||||||||
| Consumer |
$ | 269 | 659 | 43 | $ | 971 | $ | 368 | 714 | 89 | $ | 1,171 | ||||||||||||||||||||
| Credit Cards |
$ | 41 | (60 | ) | (3 | ) | $ | (22 | ) | $ | (15 | ) | (119 | ) | 2 | $ | (132 | ) | ||||||||||||||
| Direct Financing Leases |
$ | 548 | (30 | ) | (49 | ) | $ | 469 | $ | 275 | (3 | ) | (11 | ) | $ | 261 | ||||||||||||||||
| Other |
$ | — | — | — | $ | — | $ | — | — | — | $ | — | ||||||||||||||||||||
| Total Loans and Leases |
$ | 9,134 | $ | 6,303 | $ | 1,007 | $ | 16,444 | $ | 5,192 | $ | 4,713 | $ | 461 | $ | 10,366 | ||||||||||||||||
| Total Interest Earning Assets |
$ | 8,659 | $ | 7,133 | $ | 851 | $ | 16,643 | $ | 6,623 | $ | 4,993 | $ | 511 | $ | 12,127 | ||||||||||||||||
| Liabilities |
||||||||||||||||||||||||||||||||
| Interest Bearing Deposits: |
||||||||||||||||||||||||||||||||
| NOW |
$ | (3 | ) | 9 | — | $ | 6 | $ | 9 | (1 | ) | — | $ | 8 | ||||||||||||||||||
| Savings Accounts |
$ | (25 | ) | — | — | $ | (25 | ) | $ | 67 | (3 | ) | (1 | ) | $ | 63 | ||||||||||||||||
| Money Market |
$ | 81 | 1,863 | 182 | $ | 2,126 | $ | (116 | ) | 49 | (6 | ) | $ | (73 | ) | |||||||||||||||||
| TDOA’s & IRA’s |
$ | 25 | 261 | 13 | $ | 299 | $ | 1 | 120 | — | $ | 121 | ||||||||||||||||||||
| Certificates of Deposit < $100,000 |
$ | 232 | 1,091 | 117 | $ | 1,440 | $ | (94 | ) | 800 | (50 | ) | $ | 656 | ||||||||||||||||||
| Certificates of Deposit > $100,000 |
$ | 683 | 2,271 | 324 | $ | 3,278 | $ | 494 | 1,648 | 356 | $ | 2,498 | ||||||||||||||||||||
| Total Interest Bearing Deposits |
$ | 993 | $ | 5,495 | $ | 636 | $ | 7,124 | $ | 361 | $ | 2,613 | $ | 299 | $ | 3,273 | ||||||||||||||||
| Borrowed Funds: |
||||||||||||||||||||||||||||||||
| Federal Funds Purchased |
$ | 509 | 7 | 131 | $ | 647 | $ | (4 | ) | 30 | (9 | ) | $ | 17 | ||||||||||||||||||
| Repurchase Agreements |
$ | (17 | ) | 81 | (13 | ) | $ | 51 | $ | 16 | 15 | 3 | $ | 34 | ||||||||||||||||||
| Short Term Borrowings |
$ | 2,169 | 362 | 952 | $ | 3,483 | $ | 115 | 302 | 123 | $ | 540 | ||||||||||||||||||||
| Long Term Borrowings |
$ | (691 | ) | 306 | (141 | ) | $ | (526 | ) | $ | 202 | (4 | ) | (1 | ) | $ | 197 | |||||||||||||||
| TRUPS |
$ | 519 | 404 | 97 | $ | 1,020 | $ | 168 | 543 | 64 | $ | 775 | ||||||||||||||||||||
| Total Borrowed Funds |
$ | 2,489 | $ | 1,160 | $ | 1,026 | $ | 4,675 | $ | 497 | $ | 886 | $ | 180 | $ | 1,563 | ||||||||||||||||
| Total Interest Bearing Liabilities |
$ | 3,482 | $ | 6,655 | $ | 1,662 | $ | 11,799 | $ | 858 | $ | 3,499 | $ | 479 | $ | 4,836 | ||||||||||||||||
| Net Interest Income |
$ | 5,177 | $ | 478 | $ | (811 | ) | $ | 4,844 | $ | 5,765 | $ | 1,494 | $ | 32 | $ | 7,291 | |||||||||||||||
| (1) | Yields on tax exempt income have not been computed on a tax equivalent basis. |
As shown above, pure volume variances contributed $5.2 million to net interest income in 2006 relative to 2005. The positive volume variance is mainly due to growth in average interest-earning assets, as shown in the Average Balances and Rates table. Average interest-earning assets were $103 million higher in 2006 than in 2005, an increase of 11% caused by growth of $116 million, or 16%, in average loan balances partially offset by a decline of $13 million, or 6%, in average investment balances. Average non-earning assets declined slightly to 9% of average total assets in 2006 from 10% in 2005, although the favorable impact of that shift was offset by the fact that average demand deposits declined to 24% of average assets in 2006 from 26% in 2005. The volume variance was also
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negatively impacted by a shift on the liability side from lower-cost deposits to higher-cost borrowed funds. The average balance of borrowed funds was $54 million higher in 2006 than in 2005, an increase of 37%, while average interest-bearing deposits increased by only $36 million, or 7%, for the same time periods.
The addition of higher-cost short-term borrowings also impacted the rate variance, as evidenced by the 148 basis point increase in the cost of borrowed funds relative to only a 116 basis point increase in the cost of interest-bearing deposits for 2006 relative to 2005. The fact that an increasing proportion of our money market accounts are higher-cost sweep account balances is another factor that negatively impacted the rate variance. The average cost of money market accounts was 163 basis points higher in 2006 than in 2005. Overall, the weighted average cost of interest-bearing liabilities increased by 131 basis points while the weighted average yield on interest-earning assets increased by only 95 basis points, contributing to an unfavorable rate variance of $478,000 for the year. The recovery of $536,000 in interest and fees in the third quarter of 2005 added approximately 5 basis points to the yield on average earning assets for 2005, and was also a contributing factor to the unfavorable rate variance from 2005 to 2006. The rate variance would have been even greater if not for the Company’s large net interest position, which is the difference between interest-earning assets and interest-bearing liabilities. The Company’s net interest position averaged $244 million in 2005, the base period for the rate variance calculations, thus the yield increase for earning assets was applied to a substantially larger volume than the rate increase for interest-bearing liabilities.
The Company’s net interest margin, which is tax-equivalent net interest income expressed as a percentage of average interest-earning assets, is affected by many of the same factors discussed relative to rate and volume variances. Our net interest margin was 5.58% in 2006 as compared to 5.64% in 2005, a drop of 6 basis points. The Company’s interest rate risk position is slightly asset-sensitive, meaning that all else being equal the Company’s net interest margin will be lower during periods when short-term interest rates are falling and higher when rates are rising. Short-term interest rates were rising during the first half of 2006 and flat for the latter half of 2006. The positive impact of rising rates in the first half of 2006 was offset by relatively low-margin growth and a drop in average demand deposit balances and low-cost core deposits, and our net interest margin has been declining since mid-2006 when short-term rates stopped increasing. By year-end our net interest margin was approximately 5.35%, and we expect that it will average about that in 2007 if core deposits grow as anticipated, although no assurance can be given in that regard. The net interest margin for earning assets added in 2006 is estimated at around 3%, much lower than the Company’s net interest margin on pre-existing interest-earning assets since they were funded by relatively expensive FHLB borrowings and brokered deposits. While causing net interest margin compression, this low-margin growth in earning assets has augmented net interest income and enhanced our return on equity.
As with 2006, the positive volume variance in 2005 was mainly due to growth in average interest-earning assets. Average interest-earning assets increased $109 million, or 13%, for 2005 relative to 2004, largely due to growth of $71 million, or 11%, in average loan balances. Average investment balances increased by $37 million, or 22%, in 2005 relative to 2004, due to a leverage strategy implemented in April 2004 that added approximately $100 million in mortgage-backed securities to interest-earning assets and a like amount of similar-duration FHLB borrowings to interest-bearing liabilities. Average non-earning assets were about 10% of average total assets in both 2005 and 2004, however the average balance of demand deposits, other liabilities, and shareholders’ equity increased to 34% of average assets in 2005 from 32% in 2004 due in large part to strong growth in average demand deposit balances. The favorable rate variance in 2005 was due in part to the recovery of $536,000 in interest on a note that was sold during the year and the accelerated recognition of $80,000 in fees on a participation loan that prepaid, but was caused mainly by our large net interest position. The Company’s net interest margin was 5.64% in 2005 relative to 5.49% in 2004, an increase of 15 basis points. During 2005 our net interest margin rose in strong correlation to increases in short-term market interest rates, and was also favorably impacted by the aforementioned interest recovery.
Provision for Loan and Lease Losses
Credit risk is inherent in the business of making loans. The Company sets aside an allowance or reserve for loan and lease losses through charges to earnings, which are shown in the income statement as the provision for loan and lease losses. Specifically identifiable and quantifiable losses are immediately charged off against the allowance. The loan and lease loss provision is determined by conducting a monthly evaluation of the adequacy of the Company’s allowance for loan and lease losses, and charging the shortfall, if any, to the current month’s expense. This has the effect
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of creating variability in the amount and frequency of charges to the Company’s earnings. The procedures for monitoring the adequacy of the allowance, as well as detailed information concerning the allowance itself, are included below under “Allowance for Loan and Lease Losses”.
The Company’s provision for loan and lease losses was $3.9 million in 2006, $3.2 million in 2005, and $3.5 million in 2004. The loan loss provision was higher in 2006 because of robust growth in loans and a higher degree of uncertainty (and corresponding loan loss allowance increase) with regard to certain classified loans, as well as the recovery in 2005 of previously charged-off balances which enabled a significant reduction in the loan loss provision during that year. Those 2005 recoveries, combined with a $2.1 million reduction in non-performing loans and overall improvement in credit quality in 2005 relative to 2004, contributed to a reduction of $323,000 in the provision in 2005 despite adding $2.0 million to the reserve for a $2.5 million unsecured commercial loan that was ultimately charged off during that year.
Because the provision exceeded net charge-offs in 2006, the allowance for loan losses increased by $2.2 million during the year, rising to 1.3% of total gross loans and leases at the end of 2006 from 1.26% at the end of 2005. Subsequent to a thorough review of the allowance relative to the current size, composition and quality of the Company’s loan and lease portfolio, it has been judged by management to be adequate to absorb currently identified potential losses as well as any likely future losses.
Non-interest Revenue and Operating Expense
The following table sets forth the major components of the Company’s non-interest revenue and other operating expense, along with relevant ratios, for the years indicated:
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| Non Interest Revenue/Expense (dollars in thousands, unaudited) |
2006 | % of Total | 2005 | % of Total | 2004 | % of Total | |||||||||||||||
| NON INTEREST REVENUE: |
|||||||||||||||||||||
| Service charges on deposit accounts |
$ | 6,049 | 53.95 | % | $ | 5,575 | 60.22 | % | $ | 5,900 | 60.25 | % | |||||||||
| Credit card fees |
$ | 968 | 8.63 | % | $ | 817 | 8.83 | % | $ | 704 | 7.19 | % | |||||||||
| Checkcard fees |
$ | 922 | 8.22 | % | $ | 696 | 7.52 | % | $ | 534 | 5.45 | % | |||||||||
| Other service charges & fees |
$ | 2,756 | 24.58 | % | $ | 2,283 | 24.66 | % | $ | 1,910 | 19.51 | % | |||||||||
| BOLI Income |
$ | 774 | 6.90 | % | $ | 792 | 8.55 | % | $ | 487 | 4.97 | % | |||||||||
| Gains on sales of loans |
$ | 79 | 0.71 | % | $ | 523 | 5.65 | % | $ | 330 | 3.37 | % | |||||||||
| (Loss) Gains on sale of investment securities |
$ | 9 | 0.08 | % | $ | (394 | ) | -4.26 | % | $ | 19 | 0.20 | % | ||||||||
| (Loss) on tax credit investment |
$ | (940 | ) | -8.38 | % | $ | (1,092 | ) | -11.80 | % | $ | (469 | ) | -4.79 | % | ||||||
| Other |
$ | 595 | 5.31 | % | $ | 58 | 0.63 | % | $ | 377 | 3.85 | % | |||||||||
| Total non-interest revenue |
$ | 11,212 | 100.00 | % | $ | 9,258 | 100.00 | % | $ | 9,792 | 100.00 | % | |||||||||
| As a % of average interest-earning assets |
1.10 | % | 1.01 | % | 1.22 | % | |||||||||||||||
| OTHER OPERATING EXPENSES: |
|||||||||||||||||||||
| Salaries and employee benefits |
$ | 16,770 | 49.55 | % | $ | 15,648 | 47.95 | % | $ | 13,919 | 47.49 | % | |||||||||
| Occupancy costs |
|||||||||||||||||||||
| Furniture & Equipment |
$ | 3,228 | 9.54 | % | $ | 3,192 | 9.78 | % | $ | 3,266 | 11.14 | % | |||||||||
| Premises |
$ | 3,277 | 9.68 | % | $ | 2,964 | 9.08 | % | $ | 2,743 | 9.36 | % | |||||||||
| Advertising and Marketing Costs |
$ | 1,022 | 3.02 | % | $ | 1,524 | 4.67 | % | $ | 1,241 | 4.23 | % | |||||||||
| Data Processing Costs |
|||||||||||||||||||||
| Item processing costs |
$ | — | 0.00 | % | $ | — | 0.00 | % | $ | 8 | 0.03 | % | |||||||||
| Other data processing |
$ | 1,427 | 4.22 | % | $ | 1,194 | 3.66 | % | $ | 1,079 | 3.68 | % | |||||||||
| Deposit Services Costs |
$ | 1,811 | 5.35 | % | $ | 1,303 | 3.99 | % | $ | 1,168 | 3.98 | % | |||||||||
| Loan Services Costs |
|||||||||||||||||||||
| Loan Processing |
$ | 297 | 0.88 | % | $ | 281 | 0.86 | % | $ | 383 | 1.31 | % | |||||||||
| ORE Owned |
$ | 80 | 0.24 | % | $ | 617 | 1.89 | % | $ | 345 | 1.18 | % | |||||||||
| Credit Card |
$ | 700 | 2.07 | % | $ | 613 | 1.88 | % | $ | 599 | 2.04 | % | |||||||||
| Other loan services |
$ | — | 0.00 | % | $ | 8 | 0.02 | % | $ | 2 | 0.01 | % | |||||||||
| Other Operating Costs |
|||||||||||||||||||||
| Telephone & data communications |
$ | 825 | 2.44 | % | $ | 846 | 2.59 | % | $ | 766 | 2.61 | % | |||||||||
| Postage & mail |
$ | 380 | 1.12 | % | $ | 315 | 0.98 | % | $ | 389 | 1.33 | % | |||||||||
| Other |
$ | 1,076 | 3.18 | % | $ | 827 | 2.54 | % | $ | 741 | 2.53 | % | |||||||||
| Professional Services Costs |
|||||||||||||||||||||
| Legal & Accounting |
$ | 1,121 | 3.31 | % | $ | 1,296 | 3.97 | % | $ | 840 | 2.86 | % | |||||||||
| Other professional service |
$ | 1,083 | 3.20 | % | $ | 1,215 | 3.72 | % | $ | 1,047 | 3.57 | % | |||||||||
| Stationery & Supply Costs |
$ | 598 | 1.77 | % | $ | 683 | 2.09 | % | $ | 673 | 2.30 | % | |||||||||
| Sundry & Tellers |
$ | 146 | 0.43 | % | $ | 108 | 0.33 | % | $ | 102 | 0.35 | % | |||||||||
| Total other operating expense |
$ | 33,841 | 100.00 | % | $ | 32,634 | 100.00 | % | $ | 29,311 | 100.00 | % | |||||||||
| As a % of average interest-earning assets |
3.32 | % | 3.57 | % | 3.64 | % | |||||||||||||||
| Net non-interest income as a % of average interest-earning assets |
|
-2.22 | % | -2.56 | % | -2.42 | % | ||||||||||||||
| Efficiency Ratio (tax-equivalent) |
49.63 | % | 52.64 | % | 54.04 | % | |||||||||||||||
Because the percentage increase in net interest plus other income was higher than the increase in non-interest expense, the Company’s tax-equivalent overhead efficiency ratio declined to 49.6% for 2006, relative to 52.6% for 2005 and 54.0% in 2004. The overhead efficiency ratio represents total operating expense divided by the sum of fully tax-equivalent net interest and non-interest income, with the provision for loan losses, investment gains and losses, and other extraordinary income and expenses excluded from the equation.
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Non-interest income increased by $2.0 million, or 21%, in 2006 relative to 2005, due in part to the impact of non-recurring items but mainly from strong increases in service charges on deposits, check card interchange fees, and operating lease income. The Company’s 2005 results reflect an overall decline of $534,000, or 5%, in non-interest income relative to 2004, primarily because of a drop in service charges on deposit accounts and several non-recurring events. Non-interest income increased to 1.1% of average interest-earning assets in 2006 from 1.0% in 2005.
The primary sources of other operating income for the Company include the categories itemized in the table above. Items of a non-recurring nature that impacted non-interest income in 2006 include a $100,000 gain upon the outsourcing of merchant services to First Data, as discussed in the “Recent Developments” section, and an $88,000 gain on a life insurance policy, both of which are included in “Other” non-interest revenue. Non-recurring items in 2005 include a $523,000 gain on the bulk sale of $21 million in residential mortgage loans, a $406,000 loss on the sale of investment securities resulting from a year-end repositioning of the portfolio, gains on the sale of OREO totaling $127,000 that are reflected in the “Other” category, and write-downs of our investment in Diversified Holdings, Inc. totaling $570,000 that are also included in “Other”. In 2004, the principal non-recurring items include a $297,000 adjustment reducing BOLI income, as well as approximately $110,000 in gains from the sale of OREO. The “Other” category in non-interest income increased to $595,000 in 2006 from only $58,000 in 2005, due almost entirely to the non-recurring items noted herein.
The largest component of other operating income, service charges on deposit accounts, increased by $474,000, or 9% in 2006 primarily because of higher returned item and overdraft charges resulting from higher levels of activity, although they declined as a percentage of total non-interest revenue because of the impact of non-recurring items on total non-interest revenue. Service charges fell by $325,000 in 2005 despite fairly significant increases in average transaction account balances, due to a lower percentage of returned item and overdraft fees relative to transaction accounts. The Company’s ratio of service charge income to average transaction accounts (demand and interest-bearing NOW accounts) was 1.8% in 2006, 1.7% in 2005, and 2.2% in 2004. The drop in 2005 is due in part to growth in accounts that are initially free of service charges. In time, as these free accounts generate more returned item and overdraft fees the percentage should gradually increase, although no guarantee can be given in that regard. Free accounts also provide interest-free or low-cost funding, expand the Company’s customer base, and increase cross-sell opportunities for other Bank products such as consumer loans and relatively low-cost savings accounts.
Other service charges and fees constitute the second largest portion of non-interest income, with the principal components consisting of operating lease income, dividends received on restricted stock, currency order fees, and ATM fees. Other service charges and fees totaled $2.8 million in 2006, $2.3 million in 2005, and $1.9 million in 2004. In 2006, the largest year-over-year changes within this category were higher operating lease income and higher dividends received on FHLB stock. In 2005 the most significant increases were in leasing income and service charge income from currency orders. Other service charges and fees were about 25% of total non-interest revenue in 2006 and 2005, up from 20% in 2004 due to the growing impact of operating lease income and higher FHLB dividends.
Credit card fees include credit card interchange fees and credit card annual fees as primary components. Credit card fees increased $151,000, or 18%, in 2006 relative to 2005, due primarily to a higher level of activity. These fees were about 9% of total non-interest income in 2006 and 2005, up from 7% in 2004. Checkcard fees, mostly checkcard interchange fees, increased by $226,000, or 32%, in 2006, due to an increase in the number of cards and higher usage per card. As with credit card fees, checkcard fees are trending up as a percentage of non-interest revenue.
BOLI income declined by $18,000, or 2%, in 2006 relative to 2005. At December 31, 2006 the Company had $25.0 million invested in single-premium “general account” BOLI, with an interest credit rate that does not change frequently and is floored at no less than 3%. Income from this BOLI is used to fund expenses associated with executive salary continuation plans and a directors’ retirement plan. In addition, however, as of the same date the Company had approximately $1.5 million invested in “separate account” BOLI used to hedge deferred compensation arrangements for certain directors and senior officers. This separate account BOLI has returns pegged to participant-directed investment allocations, and is thus subject to loss of principal depending on equity market movements. The decline in BOLI income was mainly the result of lower returns on separate account BOLI linked to deferred compensation balances. Reflected in the year-end 2006 balance of general account BOLI is a $6 million investment
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made in December 2006, which is expected to add approximately $240,000 to BOLI income in 2007, although no assurance can be given in that regard. The increase in BOLI income in 2005 relative to 2004 is mainly due to an adjustment in 2004 that reduced BOLI income by $297,000. The income adjustment stems from certain BOLI accounts that had been carried on the Company’s books gross of potential surrender charges, but which were written down in 2004 to reflect such charges.
Income from loan sales was $79,000 in 2006, $523,000 in 2005, and $330,000 in 2004. The 85% decline in 2006 relative to 2005, and the 58% increase in 2005 relative to 2004 is due mainly to the first quarter 2005 sale of $21 million in residential mortgage loans. The Company still originates a limited number of residential mortgage loans (primarily those associated with its all-in-one “construction through permanent financing” product), but since the bulk loan sale in 2005 we have been holding most newly originated residential mortgage loans in our loan portfolio. In past years we were much more active in the residential mortgage lending business, but we currently refer the majority of our residential mortgage loan customers to Genpact Mortgage Services (formerly Moneyline Lending Services), which pays the Company referral fees for successfully closed loans. Genpact fees are reflected in other service charges, commissions and fees, and totaled $67,000 in 2006, $95,000 in 2005 and $72,000 in 2004.
While there were negligible gains on investment securities in 2006 and 2004, the sale of approximately $13 million in underperforming investment securities in December 2005 resulted in a loss of $406,000, although this was partially offset by earlier gains on called securities and the net loss for 2005 was $394,000. In addition to non-recurring losses generated by investment portfolio activities, recurring losses on our tax credit investments are also netted out of non-interest revenue and are shown as a separate line item in the table above because of their relative size. The losses represent our allocation of net losses generated by the operations of low-income housing tax credit funds, and are an expected component of our limited partnership tax credit fund investments that are factored into the initial assessment of projected returns. The losses, which reduce the balance of tax credit fund investments shown in other assets, increased by $152,000 in 2006 relative to 2005, and by $623,000 in 2005 relative to 2004, due in large part to additional investments in newly formed tax credit funds.
We turn now to a discussion of operating expense, which increased by only $1.2 million, or 4% in 2006 relative to 2005, primarily because a $502,000 drop in advertising and marketing expenses helped offset increases in other areas but also because non-recurring expenses had a slightly smaller impact in 2006. Operating expense declined to 3.3% of average interest-earning assets in 2006 from 3.6% in 2005. Operating expense increased $3.3 million, or 11%, in 2005 relative to 2004, however it declined slightly as a percentage of average earning assets.
For a detailed discussion of variances in other operating expenses, the logical starting place is the single largest component, salaries and employee benefits. Because they comprise such a significant portion of total operating expense, salaries and employee benefits typically experience a larger dollar increase than any other category. True to form, the year-over-year growth in salaries and benefits in 2006 was $1.1 million or 7%, and in 2005 was $1.7 million, or 12%. For 2006, salaries alone increased by $1.3 million, or 12%, due to an average of 5% for regular annual pay increases, a $314,000 accrual for stock option expense, the impact of additional branch and administrative staff, and the impact of revised incentive compensation plans. The full impact of staff additions for our Reedley and Bakersfield Riverlakes branches was felt in 2006, along with staff hired later in the year for our Delano branch which is now slated for a March 2007 opening. Salaries expense is net of estimated salaries relating directly to the origination of loans, which are deferred and amortized as a yield adjustment pursuant to FAS 91 and totaled $3.7 million in 2006, $3.4 million in 2005, and $3.5 million in 2004. The cost of employee benefits fell by $186,000, or 4%, in 2006, due to a $200,000 reduction in workers compensation premiums and a $165,000 drop in salary continuation plan accruals. Salaries and employee benefits were 50% of total operating expense in 2006, compared to 48% in 2005 and 47% in 2004, although they have been declining as a percentage of average earning assets. The number of full-time equivalent employees was 350 at the end of 2006, relative to 351 at the end of 2005 and 344 at the end of 2004. The slight decline at the end of 2006 relative to 2005 is due to the relatively large number of open positions existing at the end of 2006.
The annual increase in 2006 for total rent and occupancy costs, including furniture and equipment expenses, was $349,000, or 6%. The increase represents higher rent and depreciation associated with the new branches added at the end of 2005 and the beginning of 2006, as well as slight inflationary increases for other leased locations and higher
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utility costs. The increase in 2005 was only $147,000, or 2%, relative to 2004. A non-recurring charge-off of $145,000 in obsolete telephone equipment in 2004 minimized the increase in 2005 relative to 2004. Rent and occupancy costs were 19% of total operating expense in 2006 and 2005, down from 21% in 2004.
Advertising and marketing costs declined by $502,000, or 33%, in 2006 relative to 2005, in large part because of the discontinuation of a direct-mail marketing campaign run during 2005, but also due to lower newspaper and radio advertising expenses and because graphics design was brought in-house in 2006. In 2005, advertising and marketing costs increased by $283,000, or 23%, because of the aforementioned marketing campaign. Management expects total marketing expense to increase by around $800,000 in 2007 as the result of deposit initiatives currently underway.
Total data processing costs increased by $233,000, or 20%, in 2006 relative to 2005, but 2006 expenses include a non-recurring $358,000 early termination fee paid to Digital Insight in connection with our internet banking platform conversion. While resulting in a sizeable one-time fee, the conversion should reduce expenses by over $200,000 per year going forward, although no assurance can be given that the projected savings will be realized. In 2005, data processing expenses increased by $107,000, or 10%, due to the commencement of maintenance fees on our core processing system. Data processing costs would have increased even more if not for the fact that Federal Reserve Bank processing charges were included in this category in 2005, but moved to Deposit services costs in 2006.
Deposit services costs increased by $508,000, or 39% in 2006 relative to 2005, in large part because Federal Reserve Bank processing charges are in deposit services costs in 2006 but are reflected in data processing costs for 2005. These charges totaled $334,000 in 2006. Other costs in deposit services, such as ATM network costs, courier costs, and check card processing costs, also show sizeable increases in 2006. In 2005, the increase in deposit services costs was $135,000, or 12%, due to higher armored car expenses, ATM servicing costs, check card processing costs, and gift card costs. Loan services expenses were down by a combined $442,000, or 29% in 2006 relative to 2005. The primary cause of this decrease is that 2006 expenses are net of a $72,000 non-recurring recovery, and include only $133,000 in OREO write-downs relative to $550,000 in OREO write-downs in 2005 expenses. Loan services expenses increased by $190,000, or 14% in 2005 relative to 2004, because of the OREO write-downs in 2005.
The “other operating costs” category includes telecommunications, postage, and other miscellaneous costs, and totaled $2.3 million in 2006, $2.0 million in 2005, and $1.9 million in 2004. Telecommunications expense fell slightly in 2006 as the result of a more efficient configuration, but increased by $80,000, or 10%, in 2005. Postage expense increased by $65,000 in 2006 but shows a decline of $74,000 for 2005, due primarily to the timing of payments. Other miscellaneous operating expenses increased $249,000, or 30% in 2006 in comparison to 2005, and by $86,000, or 12% for 2005 over 2004. Increases in both years were driven by higher depreciation on operating leases, resulting from an increasingly larger volume of leasing business.
Legal and accounting costs were down by $175,000 in 2006, due in part to a non-recurring legal recovery of $76,000 in 2006 but also because of the fact that 2005 includes $200,000 in audit costs relating to 2004. These costs were up by $456,000 in 2005, due primarily to a $200,000 in SOX 404 audit costs for 2004 that were expensed in 2005 and an increase in legal costs related to collections. The cost of other professional services fell by $132,000, or 11% in 2006 due to a drop in accruals for the directors’ retirement plan, and increased by $168,000, or 16% in 2005, due principally to increased costs associated with the directors’ retirement and deferred fee plans.
Income Taxes
The Company’s provision for federal and state income taxes was $10.0 million in 2006, $8.1 million in 2005, and $7.2 million for 2004. This represents 34% of income before taxes in 2006, 33% in 2005, and 35% in 2004. The effective tax rate was higher in 2004 than in either 2006 or 2005, due in part to a $400,000 adjustment in 2004 associated with the filing of amended 2002 tax returns to exclude the benefit of the Bank’s real estate investment trust (“REIT”). REIT benefits were excluded subsequent to our receipt of an adverse interpretation of existing law that was released by the California Franchise Tax Board on December 31, 2003. Without the adjustment in 2004 the rate would have been 33%, the same as in 2005. The accrual rate increased slightly in 2006 largely because stock option expense, which wasn’t recognized in operating results in either 2005 or 2004, is not allowed as a tax deduction.
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The Company sets aside its provision for income taxes on a monthly basis. As indicated in Note 9 in the Notes to the Consolidated Financial Statements, the amount of such provision is determined by applying the Company’s statutory income tax rates to pre-tax book income as adjusted for permanent differences between pre-tax book income and actual taxable income. These permanent differences include but are not limited to tax-exempt interest income, increases in the cash surrender value of BOLI, California Enterprise Zone deductions, certain expenses that are not allowed as tax deductions, and tax credits.
Tax-exempt interest income is generated primarily by the Company’s investments in state, county and municipal bonds, which provided $2.0 million in federal tax-exempt income in 2006, $1.5 million in 2005, and $1.3 million in 2004. Although not reflected in the investment portfolio, the company also has total investments of $11.8 million in low-income housing tax credit funds as of December 31, 2006, including a $2 million investment commitment made in July 2006. These investments have generated substantial tax credits for the past few years, with about $1.4 million in credits available for the 2006 tax year and $1.3 million in tax credits realized in 2005. The investments are expected to generate an additional $11.1 million in aggregate tax credits from 2007 through 2018; however, the credits are dependent upon the occupancy level of the housing projects and income of the tenants and cannot be projected with complete certainty.
Some items of income and expense are recognized in different years for tax purposes than when applying generally accepted accounting principles, leading to timing differences between the Company’s actual tax liability and the amount accrued for this liability based on book income. These temporary differences comprise the “deferred” portion of the Company’s tax expense, which is accumulated on the Company’s books as a deferred tax asset or deferred tax liability until such time as it reverses. At the end of 2006, the Company had a net deferred tax asset of $5.0 million.
Financial Condition
A comparison between the summary year-end balance sheets for 2002 through 2006 was presented previously in the table of Selected Financial Data (see Item 6 above). As indicated in that table, the Company’s total assets, loans, deposits and shareholders’ equity have grown each year for the past four years. The Company experienced its most pronounced growth in assets during 2004, with total assets increasing by $196 million, or 24%, due to the aforementioned leverage strategy and strong organic loan growth. Growth in 2006 was almost as robust, with total assets growing by $162 million, or 15%, due to growth in loans. Deposits lagged behind in 2006, growing by only $53 million, or 6%, even with a $45 million increase in wholesale-source brokered deposits. Total assets grew by only $55 million, or 6%, in 2005 because of the sale of $21 million in mortgage loans and the prepayment of an $8 million loan participation. Significant changes in the relative size of balance sheet components in 2006 include net loans and leases, which increased to 72% of total assets at the end of 2006 from 69% at the end of 2005, and investment securities, which experienced an offsetting decline to 16% of total assets at the end of 2006 from 18% at the end of 2005. On the liability side, deposits declined to 77% of total liabilities at December 31, 2006 from 84% of total liabilities at December 31, 2005, with an offsetting increase in short-term FHLB borrowings, which increased to 16% of total liabilities at the end of 2006 from 7% at the end of 2005. Within deposits, non-interest bearing deposits declined to 32% of total deposits from 35% during the same time period. The major components of the Company’s balance sheet are individually analyzed below, along with off-balance sheet information.
Loan and Lease Portfolio
The Company’s loan and lease portfolio represents the single largest portion of invested assets, substantially greater than the investment portfolio or any other asset category, and the quality and diversification of the loan and lease portfolio are important considerations when reviewing the Company’s financial condition. The Company is not involved with chemicals or toxins that might have an adverse effect on the environment, thus its primary exposure to environmental legislation is through its lending activities. The Company’s lending procedures include steps to identify and monitor this exposure in an effort to avoid any related loss or liability.
As noted above, loan and lease balances grew at a faster pace than total assets during 2006, and thus increased as a percentage of the total. Since loans grew at a much faster rate than deposits, the ratio of net loans and leases to deposits increased to 100.5% at the end of 2006 from 89.5% at the end of 2005. Demand for loans remains relatively
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strong in many areas within the Company’s markets and competition continues to intensify, especially in Fresno and Bakersfield. To help ensure that we remain competitive, we make every effort to be flexible and creative in our approach to structuring loans without compromising credit quality.
The Selected Financial Data table in Item 6 above reflects the amount of loans and leases outstanding at December 31st for each year from 2002 through 2006, net of deferred fees and origination costs and the allowance for loan and lease losses. The Loan and Lease Distribution table that follows sets forth the Company’s gross loans and leases outstanding and the percentage distribution in each category at the dates indicated. The amounts shown in the table do not reflect any deferred loan fees or deferred origination costs, nor is the allowance deducted.
Loan and Lease Distribution
| As of December 31, | ||||||||||||||||||||
| (dollars in thousands) |
2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||||
| Agricultural |
$ | 13,193 | $ | 9,898 | $ | 13,146 | $ | 13,693 | $ | 11,030 | ||||||||||
| Commercial and Industrial |
$ | 113,644 | $ | 100,545 | $ | 100,042 | $ | 93,287 | $ | 83,109 | ||||||||||
| Real Estate: |
||||||||||||||||||||
| Secured by Commercial/Professional Office Properties including construction and development |
$ | 420,973 | $ | 363,094 | $ | 336,065 | $ | 306,635 | $ | 238,709 | ||||||||||
| Secured by Residential Properties |
$ | 177,448 | $ | 128,735 | $ | 126,241 | $ | 98,891 | $ | 91,084 | ||||||||||
| Secured by Farmland |
$ | 53,668 | $ | 45,353 | $ | 37,648 | $ | 25,281 | $ | 16,931 | ||||||||||
| Held for Sale |
$ | — | $ | — | $ | 440 | $ | 513 | $ | 653 | ||||||||||
| Total Real Estate |
$ | 652,089 | $ | 537,182 | $ | 500,394 | $ | 431,320 | $ | 347,377 | ||||||||||
| Small Business Administration loans |
$ | 25,946 | $ | 24,190 | $ | 21,547 | $ | 21,964 | $ | 21,918 | ||||||||||
| Consumer Loans |
$ | 54,568 | $ | 51,006 | $ | 48,992 | $ | 41,106 | $ | 39,825 | ||||||||||
| Direct Financing Leases |
$ | 20,150 | $ | 10,138 | $ | 3,490 | $ | 792 | $ | — | ||||||||||
| Consumer Credit Cards |
$ | 8,418 | $ | 8,401 | $ | 8,665 | $ | 8,519 | $ | 9,359 | ||||||||||
| Total Loans and Leases |
$ | 888,008 | $ | 741,360 | $ | 696,276 | $ | 610,681 | $ | 512,618 | ||||||||||
| Percentage of Total Loans and Leases |
||||||||||||||||||||
| Agricultural |
1.49 | % | 1.34 | % | 1.89 | % | 2.24 | % | 2.15 | % | ||||||||||
| Commercial and Industrial |
12.80 | % | 13.56 | % | 14.37 | % | 15.27 | % | 16.21 | % | ||||||||||
| Real Estate: |
||||||||||||||||||||
| Secured by Commercial/Professional Office Properties including construction and development |
47.41 | % | 48.98 | % | 48.27 | % | 50.21 | % | 46.57 | % | ||||||||||
| Secured by Residential Properties |
19.98 | % | 17.36 | % | 18.13 | % | 16.20 | % | 17.77 | % | ||||||||||
| Secured by Farmland |
6.04 | % | 6.12 | % | 5.41 | % | 4.14 | % | 3.30 | % | ||||||||||
| Held for Sale |
0.00 | % | 0.00 | % | 0.06 | % | 0.08 | % | 0.13 | % | ||||||||||
| Total Real Estate |
73.43 | % | 72.46 | % | 71.87 | % | 70.63 | % | 67.77 | % | ||||||||||
| Small Business Administration loans |
2.92 | % | 3.26 | % | 3.09 | % | 3.60 | % | 4.27 | % | ||||||||||
| Consumer Loans |
6.14 | % | 6.88 | % | 7.04 | % | 6.73 | % | 7.77 | % | ||||||||||
| Direct Financing Leases |
2.27 | % | 1.37 | % | 0.50 | % | 0.13 | % | 0.00 | % | ||||||||||
| Consumer Credit Cards |
0.95 | % | 1.13 | % | 1.24 | % | 1.40 | % | 1.83 | % | ||||||||||
| 100.00 | % | 100.00 | % | 100.00 | % | 100.00 | % | 100.00 | % | |||||||||||
As displayed in the table, aggregate loan and lease balances increased by $375 million, or 73%, from the end of 2002 to the end of 2006. The Company’s branches and other business units generated the bulk of that growth. Overall, loan demand in the Company’s immediate market has been weighted toward loans secured by real estate. Loans secured by commercial and professional buildings increased by $58 million, or 16%, in 2006, while loans secured by residential properties increased by $49 million, or 38%. About $21 million of the increase in loans secured by residential properties is from an increase in outstanding balances on home equity loans, another $18 million is from growth in residential mortgage loans, and the remainder is in the form of commercial loans where residential real estate was taken as collateral. Loans secured by residential properties increased to 20% of total loans at December 31, 2006, from 17% at December 31, 2005.
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Real estate loans secured by farmland grew by $8 million, or 18%, during 2006, and have increased to 6% of total loans from 3% since the end of 2002. Agricultural production loan balances increased by $3 million, or 33% during 2006, but overall have been trending downward as a percentage of total loans since 2002. The Company has, to some extent, withdrawn from financing production lines, where year-to-year cash flow variations can impede the ability of borrowers to meet contractual repayment terms. With uncertain commodity prices some of our borrowers have experienced declining equity in farming operations, and many are selling farm land for alternate uses such as housing and commercial development. The Company also originates and sells agricultural mortgage loans to certain investors, and the volume of agricultural mortgage loans serviced totaled $13 million as of December 31, 2006. Total loans serviced for others numbered 44 with an aggregate balance of $17 million as of the end of 2006, as compared to 56 loans with an aggregate balance of $17 million at the end of 2005.
Commercial and industrial loans, including SBA loans, increased by a combined $15 million, or 12%, in 2006. Despite an overall trend upward for the past few years, their growth rate has lagged behind that of the aggregate portfolio and commercial loans declined to 16% of total loans at the end of 2006 from 20% at the end of 2002. The Company’s commercial loans are centered in locally-oriented commercial activities in markets where the Company has a physical presence, and this segment of the portfolio has struggled for growth as the local market has become increasingly competitive. Potential business has been passed over in some instances, and in others the Company has taken real estate collateral as an abundance of caution, which causes the loans to be classified as commercial real estate. The Company also has a business unit dedicated to SBA loans and is very active in specific SBA program lending. Further, the Company is designated as an SBA Preferred Lender, which allows greater flexibility to meet small business loan requests with a more timely credit approval process. In the past the Company has sold some SBA loans, and while we still have the ability to do so, our intention for the immediate future is to retain the SBA loans we originate. Direct finance leases are also a form of secured commercial credit, and are an increasingly popular option for our business customers. Part of the reason for the limited growth in commercial loans is the growth in direct finance leases, which increased by $10 million, or 99%, in 2006 and are now over 2% of total loans and leases.
The consumer loans category represented 6% of total loans and leases outstanding at December 31, 2006, and 7% at December 31, 2005. These balances consist primarily of automobile loans and unsecured lines of credit. Consumer loans increased by $4 million, or 7%, during 2006. Consumer credit card loans represented just 1% of total loans and leases outstanding at December 31, 2006, having declined from 2% of total loans and leases at December 31, 2002.
Loan and Lease Maturities
The following table shows the maturity distribution for total loans and leases outstanding as of December 31, 2006, including non-accruing loans. The maturity distribution is grouped by remaining scheduled principal payments that are due within three months, after three months but less than one year, after one but within five years, or after five years. The principal balance of loans due after one year is indicated by both fixed and floating rate categories.
| As of December 31, 2006 | |||||||||||||||||||||
| Loan and Lease Maturity (dollars in thousands) |
Three months or less |
Three months to twelve months |
One to five |
Over five years |
Total | Floating due after |
Fixed rate: due after | ||||||||||||||
| Agricultural |
$ | 300 | $ | 9,519 | $ | 3,374 | $ | — | $ | 13,193 | $ | 849 | $ | 2,525 | |||||||
| Commercial and Industrial (1) |
$ | 17,778 | $ | 31,167 | $ | 62,526 | $ | 28,119 | $ | 139,590 | $ | 41,230 | $ | 49,415 | |||||||
| Real Estate |
$ | 48,976 | $ | 91,365 | $ | 100,366 | $ | 411,382 | $ | 652,089 | $ | 256,260 | $ | 255,488 | |||||||
| Consumer Loans |
$ | 2,432 | $ | 4,067 | $ | 23,369 | $ | 24,700 | $ | 54,568 | $ | 22,956 | $ | 25,113 | |||||||
| Credit Cards |
$ | — | $ | — | $ | 8,418 | $ | — | $ | 8,418 | $ | 8,418 | $ | — | |||||||
| Direct Financing Leases |
$ | — | $ | 49 | $ | 12,617 | $ | 7,484 | $ | 20,150 | $ | — | $ | 20,101 | |||||||
| TOTAL |
$ | 69,486 | $ | 136,167 | $ | 210,670 | $ | 471,685 | $ | 888,008 | $ | 329,713 | $ | 352,642 | |||||||
| (1) |
Includes Small Business Administration Loans |
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For a comprehensive discussion of the Company’s liquidity position, re-pricing characteristics of the balance sheet, and sensitivity to changes in interest rates, see the “Liquidity and Market Risk” section.
Off-Balance Sheet Arrangements
In the normal course of business, the Company makes commitments to extend credit to its customers as long as there are no violations of any conditions established in contractual arrangements. These commitments are obligations that represent a potential credit risk to the Company, and a $160,000 reserve for unfunded commitments is reflected as a liability in the Company’s consolidated balance sheet at December 31, 2006. Total unused commitments to extend credit were $301 million at December 31, 2006, as compared to $317 million at December 31, 2005. Net of credit card lines available which were $40 million and $46 million at December 31, 2006 and 2005, unused commitments represented 29% and 37% of outstanding gross loans and leases at December 31, 2006 and 2005, respectively. The Company’s stand-by letters of credit totaled $29 million at December 31, 2006 and $17 million at December 31, 2005.
The effect on the Company’s revenues, expenses, cash flows and liquidity from the unused portion of the commitments to provide credit cannot be reasonably predicted, because there is no certainty that the lines of credit will ever be fully utilized. For more information regarding the Company’s off-balance sheet arrangements, see Note 11 to the financial statements located elsewhere herein.
Contractual Obligations
At the end of 2006, the Company had contractual obligations for the following payments, by type and period due:
| Payments Due by Period | |||||||||||||||
| Less than | More than | ||||||||||||||
| Total | 1 Year | 1-3 Years | 3-5 Years | 5 Years | |||||||||||
| Long-term debt obligations |
$ | 30,928,000 | $ | — | $ | — | $ | — | $ | 30,928,000 | |||||
| Operating lease obligations |
$ | 7,918,079 | $ | 1,012,803 | $ | 1,798,031 | $ | 1,537,191 | $ | 3,570,054 | |||||
| Purchase obligations |
$ | 125,398 | $ | 125,398 | $ | — | $ | — | $ | — | |||||
| Other long-term obligations |
$ | 2,810,195 | $ | 2,000,211 | $ | 750,847 | $ | 33,233 | $ | 25,904 | |||||
| Total |
$ | 41,781,672 | $ | 3,138,412 | $ | 2,548,878 | $ | 1,570,424 | $ | 34,523,958 | |||||
Non-performing Assets
Financial institutions generally have a certain level of exposure to asset quality risk, and could potentially receive less than a full return of principal and interest if a debtor becomes unable or unwilling to repay. Since loans are the most significant assets of the Company and generate the largest portion of its revenues, the Company’s management of risk related to asset quality is focused primarily on loan quality. Banks have generally suffered their most severe earnings declines as a result of customers’ inability to generate sufficient cash flow to service their debts, or as a result of the downturns in national and regional economies which have brought about declines in overall property values. In addition, certain debt securities that the Company may purchase have the potential of declining in value if the obligor’s financial capacity to repay deteriorates.
To help minimize credit quality concerns, we have established a sound approach to credit that includes well-defined goals and objectives and well-documented credit policies and procedures. The policies and procedures identify market segments, set goals for portfolio growth or contraction, and establish limits on industry and geographic credit concentrations. In addition, these policies establish the Company’s underwriting standards and the methods of monitoring ongoing credit quality. The Company’s internal credit risk controls are centered in underwriting practices, credit granting procedures, training, risk management techniques, and familiarity with loan and lease customers as well as the relative diversity and geographic concentration of our loan and lease portfolio.
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The Company’s credit risk may also be affected by external factors such as the level of interest rates, employment, general economic conditions, real estate values, and trends in particular industries or geographic markets. As a multi-community independent bank serving a specific geographic area, the Company must contend with unpredictable changes in the California and San Joaquin Valley markets. Our asset quality has suffered in the past from the impact of national and regional economic recessions, consumer bankruptcies, weather-related agricultural losses, and depressed prices for agricultural goods. While it is still premature to say with any certainty, it does not appear that the freeze that destroyed much of the orange crop in the San Joaquin Valley in early 2007 will have a material impact on the Company or any of its larger borrowers. In fact, in recent years the Company, and likewise the San Joaquin Valley, has experienced healthy growth independent of agricultural considerations. Major companies are discovering the San Joaquin Valley as an ideal location for distribution facilities, non-agricultural jobs are growing at a relatively fast rate, and comparatively low-cost housing has attracted new residents from more expensive regions of California. The Company is optimistic that the local economy will continue to flourish, but no assurance can be given that this will in fact occur.
Non-performing assets are comprised of the following: Loans and leases for which the Company is no longer accruing interest; loans and leases 90 days or more past due and still accruing interest (although they are generally placed on non-accrual when they become 90 days past due); loans and leases restructured where the terms of repayment have been renegotiated, resulting in a deferral of interest or principal; and other real estate owned (“OREO”). Management’s classification of a loan or lease as “non-accrual” is an indication that there is reasonable doubt as to the full recovery of principal or interest on the loan or lease. At that point, the Company stops accruing income from the interest, reverses any uncollected interest that had been accrued as income, and begins recognizing interest income only as cash interest payments are received and as long as the collection of all outstanding principal is not in doubt. The loans may or may not be collateralized, and collection efforts are continuously pursued. Loans or leases may be restructured by management when a borrower has experienced some change in financial status causing an inability to meet the original repayment terms and where the Company believes the borrower will eventually overcome those circumstances and make full restitution. OREO consists of properties acquired by foreclosure or similar means that management is offering or will offer for sale. The following table provides information with respect to components of the Company’s non-performing assets at the dates indicated:
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| As of December 31, | ||||||||||||||||||||
| Non-performing Assets (dollars in thousands) |
2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||||
| Nonaccrual Loans and Leases:(1) |
||||||||||||||||||||
| Agricultural |
$ | — | $ | — | $ | — | $ | 725 | $ | 15 | ||||||||||
| Commercial and Industrial |
$ | 370 | $ | — | $ | 393 | $ | 2,370 | $ | 1,070 | ||||||||||
| Real Estate |
||||||||||||||||||||
| Secured by Commercial/Professional Office Properties including construction and development |
$ | — | $ | — | $ | — | $ | 116 | $ | 350 | ||||||||||
| Secured by Residential Properties |
$ | — | $ | — | $ | — | $ | 260 | $ | 31 | ||||||||||
| Secured by Farmland |
$ | — | $ | — | $ | 1,313 | $ | 1,920 | $ | 2,343 | ||||||||||
| TOTAL REAL ESTATE |
$ | — | $ | — | $ | 1,313 | $ | 2,296 | $ | 2,724 | ||||||||||
| Small Business Administration loans |
$ | 262 | $ | 288 | $ | 255 | $ | 787 | $ | 323 | ||||||||||
| Consumer Loans |
$ | 57 | $ | 21 | $ | 168 | $ | 284 | $ | 141 | ||||||||||
| Credit Cards |
$ | — | $ | — | $ | 19 | $ | 15 | $ | 56 | ||||||||||
| Direct Financing Leases |
$ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
| SUBTOTAL |
$ | 689 | $ | 309 | $ | 2,148 | $ | 6,477 | $ | 4,329 | ||||||||||
| Loans and leases 90 days or more past due & still accruing: |
||||||||||||||||||||
| (as to principal or interest) |
||||||||||||||||||||
| Agricultural |
$ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
| Commercial and Industrial |
$ | — | $ | — | $ | — | $ | — | $ | 1,426 | ||||||||||
| Real Estate |
||||||||||||||||||||
| Secured by Commercial/Professional Office Properties including construction and development |
$ | — | $ | — | $ | — | $ | — | $ | 700 | ||||||||||
| Secured by Residential Properties |
$ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
| Secured by Farmland |
$ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
| TOTAL REAL ESTATE |
$ | — | $ | — | $ | — | $ | — | $ | 700 | ||||||||||
| Small Business Administration loans |
$ | — | $ | — | $ | 280 | $ | 206 | $ | — | ||||||||||
| Consumer Loans |
$ | — | $ | — | $ | 20 | $ | — | $ | — | ||||||||||
| Credit Cards |
$ | — | $ | — | $ | — | $ | — | $ | 12 | ||||||||||
| Direct Financing Leases |
$ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
| SUBTOTAL |
$ | — | $ | — | $ | 300 | $ | 206 | $ | 2,138 | ||||||||||
| TOTAL NON-PERFORMING LOANS AND LEASES |
$ | 689 | $ | 309 | $ | 2,448 | $ | 6,683 | $ | 6,467 | ||||||||||
| Other Real Estate Owned |
$ | — | $ | 533 | $ | 2,524 | $ | 2,784 | $ | 1,421 | ||||||||||
| Total nonperforming assets |
$ | 689 | $ | 842 | $ | 4,972 | $ | 9,467 | $ | 7,888 | ||||||||||
| Restructured loans and leases (2) |
N/A | N/A | N/A | N/A | N/A | |||||||||||||||
| Nonperforming loans and leases as % of total gross loans and leases |
0.08 | % | 0.04 | % | 0.35 | % | 1.09 | % | 1.26 | % | ||||||||||
| Nonperforming assets as a % of total gross loans and leases and other real estate owned |
0.08 | % | 0.11 | % | 0.71 | % | 1.54 | % | 1.53 | % | ||||||||||
| (1) | Additional interest income of approximately $40,993 would have been recorded for the year ended December 31, 2006 if these loans had been paid. in accordance with their original terms and had been outstanding throughout the applicable period then ended or, if not outstanding throughout the applicable period then ended, since origination. |
| (2) | A “restructured loan or lease” is one where the terms were renegotiated to provide a reduction or deferral of interest or principal because of a deterioration in the financial position of the borrower. |
Despite an increase of $370,000 in non-performing commercial loans during 2006, the aggregate balance of non-performing assets at the end of 2006 represents a drop of $153,000, or 18%, from year-end 2005 levels due to the sale of the Company’s last remaining OREO early in 2006. The increase in non-accruing commercial loans is attributable primarily to a single borrowing relationship, and it should be noted that all commercial and consumer loans shown as
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non-accrual have been allocated a loss reserve on a dollar for dollar basis. The reserve for SBA loans on non-accrual status does not include the guaranteed portion of the loans, since a loss is not probable for those balances. In 2005, non-performing assets fell $4.1 million, or 83%, from year-end 2004 levels, and they declined by $4.5 million, or 47%, during 2004. This represents an aggregate decline of $8.8 million in three years. The ratio of non-performing assets to total gross loans plus OREO also fell substantially, to 0.08% at the end of 2006, as compared to 0.11% at the end of 2005 and 0.71% at the end of 2004.
The main changes during 2005 were in loans secured by farmland, which were reduced by $1.3 million due to the sale of a non-accruing note, and OREO, which was reduced by $2.0 million. The sale of the note resulted in the recovery of $500,000 in previously charged-off principal, as well as the payment of $536,000 in interest that had not been accrued. The reduction in OREO was partly the result of $550,000 in write-downs during the year, but was also due to the sale of several properties. In 2004, the principal change was in commercial and industrial loans, which dropped due to a $1 million relationship that was brought current when the customer collected delinquent payments owed to it under a government contract, and also because we collected a $600,000 past-due balance under a USDA guarantee.
While the current level of non-performing assets represents significant improvement and is relatively low, we recognize that an increase in the dollar amount of non-accrual loans and leases is possible in the normal course of business as we expand our lending activities. We also expect occasional foreclosures as a last resort in the resolution of some problem credits.
Allowance for Loan and Lease Losses
The allowance for loan and lease losses is established through a provision for losses based on management’s evaluation of known and inherent risks in the Company’s loan and lease portfolio. The allowance is increased by provisions charged against current earnings, and reduced by net charge-offs. Loans and leases are charged off when they are deemed to be uncollectible, while recoveries are generally recorded only when cash payments are received subsequent to the charge off.
We employ a systematic methodology for determining the allowance for loan and lease losses that includes a periodic review process and adjustment of the allowance at least quarterly. Our process includes a review of individual loans and leases that have been specifically identified as problems or have characteristics that could lead to impairment, as well as detailed reviews of other loans and leases (either individually or in pools). Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for losses that management believes is appropriate at each reporting date.
Quantitative factors include our historical loss experience, delinquency and charge-off trends, collateral values, changes in non-performing loans and leases, geographic concentrations, concentrations for particular loan or collateral types, and other factors. Quantitative factors also incorporate known information about individual loans and leases, including borrowers’ sensitivity to interest rate movements and to other quantifiable external factors, such as commodity price changes and acts of nature (freezes, earthquakes, fires, etc.), that occur in a particular period. Qualitative factors are at least to some extent based on management’s judgment and experience. They include an assessment of the general economic environment in our markets and, in particular, the state of agriculture and other key industries in the San Joaquin Valley. The way a particular loan or lease might be structured, the extent and nature of waivers of existing loan policies, the results of bank regulatory examinations, model imprecision, and the expected rate of portfolio growth are additional factors that are considered. The table which follows summarizes the activity in the allowance for loan and lease losses for the years indicated:
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| As of and for the years ended December 31, | ||||||||||||||||||||
| Allowance For Loan Losses and Leases (dollars in thousands) |
2006 | 2005 | 2004 | 2003 | 2002 | |||||||||||||||
| Balances: |
||||||||||||||||||||
| Average gross loans and leases outstanding during period |
$ | 824,041 | $ | 708,002 | $ | 636,598 | $ | 550,744 | $ | 500,461 | ||||||||||
| Gross loans and leases outstanding at end of period |
$ | 888,008 | $ | 741,360 | $ | 696,276 | $ | 610,681 | $ | 512,618 | ||||||||||
| Allowance for Loan and Lease Losses: |
||||||||||||||||||||
| Balance at beginning of period |
$ | 9,330 | $ | 8,842 | $ | 6,701 | $ | 5,939 | $ | 5,675 | ||||||||||
| Provision Charged to Expense |
$ | 3,851 | $ | 3,150 | $ | 3,473 | $ | 3,105 | $ | 3,350 | ||||||||||
| Charge-offs |
||||||||||||||||||||
| Agricultural |
$ | — | $ | — | $ | 60 | $ | — | $ | 602 | ||||||||||
| Commercial & Industrial Loans (1) |
$ | 1,301 | $ | 2,864 | $ | 459 | $ | 1,491 | $ | 1,161 | ||||||||||
| Real Estate loans |
$ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
| Consumer Loans |
$ | 571 | $ | 494 | $ | 596 | $ | 542 | $ | 1,031 | ||||||||||
| Direct Financing Leases |
$ | 4 | $ | — | $ | — | $ | — | $ | — | ||||||||||
| Credit Card Loans |
$ | 344 | $ | 400 | $ | 402 | $ | 561 | $ | 580 | ||||||||||
| Overdrafts |
$ | 213 | $ | 216 | $ | 254 | $ | — | $ | — | ||||||||||
| Total |
$ | 2,433 | $ | 3,974 | $ | 1,771 | $ | 2,594 | $ | 3,374 | ||||||||||
| Recoveries |
||||||||||||||||||||
| Agricultural |
$ | 5 | $ | 747 | $ | 143 | $ | 34 | $ | 34 | ||||||||||
| Commercial & Industrial Loans (1) |
$ | 439 | $ | 325 | $ | 95 | $ | 68 | $ | 156 | ||||||||||
| Real Estate loans |
$ | — | $ | 2 | $ | — | $ | — | $ | — | ||||||||||
| Consumer Loans |
$ | 253 | $ | 95 | $ | 120 | $ | 73 | $ | 37 | ||||||||||
| Direct Financing Leases |
$ | — | $ | — | $ | — | $ | — | $ | — | ||||||||||
| Credit Card Loans |
$ | 86 | $ | 88 | $ | 71 | $ | 76 | $ | 61 | ||||||||||
| Overdrafts |
$ | 48 | $ | 55 | $ | 10 | $ | — | $ | — | ||||||||||
| Total |
$ | 831 | $ | 1,312 | $ | 439 | $ | 251 | $ | 288 | ||||||||||
| Net Loan and Lease Charge-offs |
$ | 1,602 | $ | 2,662 | $ | 1,332 | $ | 2,343 | $ | 3,086 | ||||||||||
| Balance at end of period |
$ | 11,579 | $ | 9,330 | $ | 8,842 | $ | 6,701 | $ | 5,939 | ||||||||||
| Ratios: |
||||||||||||||||||||
| Net Loan and Lease Charge-offs to Average Loans and Leases |
0.19 | % | 0.38 | % | 0.21 | % | 0.43 | % | 0.62 | % | ||||||||||
| Allowance for Loan and Lease Losses to Gross Loans and Leases at End of Period |
1.30 | % | 1.26 | % | 1.27 | % | 1.10 | % | 1.16 | % | ||||||||||
| Allowance for Loan and Lease Losses to Non-Performing Loans and Leases |
1680.55 | % | 3019.42 | % | 361.19 | % | 100.27 | % | 91.84 | % | ||||||||||
| Net Loan and Lease Charge-offs to Allowance for Loan and Lease Losses at End of Period |
13.84 | % | 28.53 | % | 15.06 | % | 34.96 | % | 51.96 | % | ||||||||||
| Net Loan and Lease Charge-offs to Provision for Loan and Lease Losses |
41.60 | % | 84.51 | % | 38.35 | % | 75.46 | % | 92.12 | % | ||||||||||
| (1) | Includes Small Business Administration Loans. |
The Company’s allowance for loan and lease losses increased by close to $2.3 million during 2006 and ended the year at $11.6 million, or 1.30% of gross loans and leases, compared to $9.3 million, or 1.26% of gross loans and leases at the end of 2005. The loss provision in 2006 totaled $3.9 million, compared to $3.2 million in 2005. Net loans charged off were $1.6 million in 2006 as compared to $2.7 million in 2005. Charge-offs in 2005 included a $2.5 million unsecured commercial loan, and net charge-offs for that year would have been much higher if not for the
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recovery of $1.3 million in principal from previously charged off loans. Net loans charged off in 2006 were 0.19% of average loans and leases, compared to 0.38% in 2005. It should be noted that prior to 2004, losses stemming from overdraft balances were included as operating losses in operating expenses and are not reflected in the table above. While uncollectible overdraft balances are currently charged off as loan losses against the allowance for loan and lease losses, related overdraft fees and charges are still reflected as operating losses.
While evolving somewhat to incorporate a greater level of detail and sophistication in the past few years, our methodology for determining the adequacy of the Company’s allowance for loan and lease losses has, for the most part, been consistently followed. As we add new products and expand our geographic coverage, we expect to continue to enhance our methodology to keep pace with the size and complexity of the loan and lease portfolio. We engage outside firms on a regular basis to independently assess our methodology and perform independent credit reviews of our loan and lease portfolio. The Company’s external auditors and credit review consultants, the FDIC, and the California Department of Financial Institutions also review the allowance for loan and lease losses as an integral part of the examination processes. Management believes that the current methodology is appropriate given our size and level of complexity. Further, management believes that the allowance for loan and lease losses at December 31, 2006 was adequate to cover known and inherent risks in the portfolio. Fluctuations in credit quality, changes in economic conditions, or other factors could induce us to augment the allowance, however, and no assurance can be given that such factors will not result in increased losses in the loan and lease portfolio in the future.
The following table provides a summary of the allocation of the allowance for loan and lease losses for specific categories at the dates indicated. The allocation presented should not be interpreted as an indication that charges to the allowance for loan and lease losses will be incurred in these amounts or proportions, or that the portion of the allowance allocated to each category represents the total amounts available for charge-offs that may occur within these categories.
| As of December 31, | ||||||||||||||||||||||||||||||
| 2006 | 2005 | 2004 | 2003 | 2002 | ||||||||||||||||||||||||||
| Allocation of Loan and Lease Loss Allowance (dollars in thousands) |
Amount | % Total (1) Loans |
Amount | % Total (1) Loans |
Amount | % Total (1) Loans |
Amount | % Total (1) Loans |
Amount | % Total (1) Loans |
||||||||||||||||||||
| Agricultural |
$ | 1,496 | 1.49 | % | $ | 64 | 1.34 | % | $ | 442 | 1.89 | % | $ | 351 | 2.24 | % | $ | 419 | 2.15 | % | ||||||||||
| Commercial and Industrial (2) |
$ | 1,470 | 15.72 | % | $ | 2,295 | 16.82 | % | $ | 4,421 | 17.46 | % | $ | 2,728 | 18.87 | % | $ | 2,529 | 20.48 | % | ||||||||||
| Real Estate |
$ | 6,866 | 73.43 | % | $ | 5,918 | 72.46 | % | $ | 2,211 | 71.87 | % | $ | 2,721 | 70.63 | % | $ | 1,538 | 67.77 | % | ||||||||||
| Consumer Loans |
$ | 1,077 | 6.14 | % | $ | 467 | 6.88 | % | $ | 884 | 7.04 | % | $ | 719 | 6.73 | % | $ | 734 | 7.77 | % | ||||||||||
| Direct Financing Leases |
$ | 212 | 2.27 | % | $ | 71 | 1.37 | % | $ | 177 | 0.50 | % | $ | — | 0.13 | % | $ | — | 0.00 | % | ||||||||||
| Consumer Credit Cards |
$ | 458 | 0.95 | % | $ | 515 | 1.13 | % | $ | 707 | 1.24 | % | $ | 182 | 1.40 | % | $ | 719 | 1.83 | % | ||||||||||
| TOTAL |
$ | 11,579 | 100.00 | % | $ | 9,330 | 100.00 | % | $ | 8,842 | 100.00 | % | $ | 6,701 | 100.00 | % | $ | 5,939 | 100.00 | % | ||||||||||
| (1) | Represents percentage of loans in category to total loans. |
| (2) | Includes Small Business Administration loans. |
Investment Portfolio
With a book value of $190 million at December 31, 2006, the investment securities portfolio is the second largest component of the Company’s interest earning assets, and the structure and composition of this portfolio is important to any analysis of the financial condition of the Company. The investment portfolio serves the following purposes: 1) it can be readily reduced in size to provide liquidity for loan balance increases or deposit balance decreases; 2) it provides a source of pledged assets for securing certain deposits and borrowed funds, as may be required by law or by specific agreement with a depositor or lender; 3) it can be used as an interest rate risk management tool, since it provides a large base of assets, the maturity and interest rate characteristics of which 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) it is an alternative interest-earning use of funds when loan demand is weak or when deposits grow more rapidly than loans; and 5) it can enhance the Company’s tax position by providing partially tax exempt income.
The Company uses two portfolio classifications for its investments: “held-to-maturity”, and “available-for-sale”. Accounting rules also allow a trading portfolio classification, but the Company has no investments that would be classified as such. The held-to-maturity portfolio can consist only of investments that the Company has both the
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intent and ability to hold until maturity, to be sold only in the event of concerns with an issuer’s credit worthiness, a change in tax law that eliminates their tax exempt status, or other infrequent situations as permitted by generally accepted accounting principles. Since the Company does not have a trading portfolio, the available-for-sale portfolio is comprised of all securities not included as “held-to-maturity”. Even though management currently has the intent and the ability to hold the Company’s marketable investments to maturity, they are all currently classified as available-for-sale to allow maximum flexibility with regard to the active management of the Company’s investment portfolio. SFAS 133 requires available-for-sale securities to be marked to market on a periodic basis with an offset to accumulated other comprehensive income, a component of equity. Monthly adjustments are made to that account to reflect changes in the market value of the Company’s available-for-sale securities.
The Company’s investment portfolio is currently composed primarily of: (1) U.S. Treasury and Agency issues for liquidity and pledging; (2) mortgage-backed securities, which in many instances can also be used for pledging, and which generally enhance the yield of the portfolio; (3) state, county and municipal obligations, which provide limited tax free income and pledging potential; and (4) other equity investments. The fourth category includes an equity investment in Farmer Mac stock, which is a required element to allow the Company to sell certain agricultural loans to this quasi-governmental agency. Securities pledged as collateral for repurchase agreements, public deposits and for other purposes as required or permitted by law were $167 million and $164 million at December 31, 2006 and 2005, respectively.
During 2006, investment portfolio balances declined $3 million, with a $13 million drop in mortgage-backed securities partially offset by a $9 million increase in municipal securities and a $1 million increase in Agency securities. The decline in mortgage-backed securities, which fell to 62% of total investment securities at the end of 2006 from 68% at the end of 2005 and 80% at the end of 2004, is primarily due to the runoff of our leverage strategy bonds, but also includes the 2005 sale of $13 million in non-leverage mortgage-backed securities in a repositioning move. Longer-duration municipal bonds have been increased in weighting over the last two years, to 28% of the total portfolio at the end of 2006 from 23% at the end of 2005 and 17% at the end of 2004, as a defensive measure against the possibility of falling bond rates. At December 31, 2006, the investment portfolio represented 16% of total assets, as compared to 18% at the end of 2005 and 20% at the end of 2004.
As can be seen on the Distribution, Rate & Yield table presented in a previous section, the average tax-equivalent yield earned on total investments increased to 4.89% in 2006 from 4.34% in 2005. The following Investment Portfolio table reflects the amortized cost and fair market values for the total portfolio for each of the categories of investments for the past three years.
| As of December 31, | ||||||||||||||||||
| 2006 | 2005 | 2004 | ||||||||||||||||
| Investment Portfolio - Available For Sale (dollars in thousands) |
Amortized Cost |
Fair Market Value |
Amortized Cost |
Fair Market Value |
Amortized Cost |
Fair Market Value | ||||||||||||
| US Treasury Securities |
$ | 501 | $ | 496 | $ | 504 | $ | 495 | $ | 506 | $ | 506 | ||||||
| US Government Agencies & Corporations |
18,035 | 17,879 | 17,360 | 17,143 | 6,013 | 6,004 | ||||||||||||
| Mortgage-backed securities (CMO) |
121,204 | 118,175 | 134,455 | 131,050 | 159,576 | 158,722 | ||||||||||||
| State & political subdivisions |
53,387 | 53,713 | 44,477 | 44,977 | 31,504 | 32,783 | ||||||||||||
| Equity securities |
6 | 9 | 6 | 11 | 6 | 9 | ||||||||||||
| Total Investment Securities |
$ | 193,133 | $ | 190,272 | $ | 196,802 | $ | 193,676 | $ | 197,605 | $ | 198,024 | ||||||
The investment maturities table below summarizes contractual maturities for the Company’s investment securities and their weighted average yields at December 31, 2006. The actual timing of principal payments may differ from remaining contractual maturities, because obligors may have the right to repay certain obligations with or without penalties.
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| As of December 31, 2006 | ||||||||||||||||||||||||||||||
| Within One Year |
After One But Within Five Years |
After Five Years But Within Ten Years |
After Ten Years |
Total | ||||||||||||||||||||||||||
| Investment Maturities - Available For Sale (dollars in thousands) |
Amount | Yield | Amount | Yield | Amount | Yield | Amount | Yield | Amount | Yield | ||||||||||||||||||||
| US Treasury securities |
$ | 496 | 3.16 | % | $ | — | — | $ | — | — | $ | — | — | $ | 496 | 3.16 | % | |||||||||||||
| US Government agencies & corporations |
2,978 | 4.16 | % | 14,206 | 4.54 | % | 695 | 5.55 | % | — | — | 17,879 | 4.51 | % | ||||||||||||||||
| Mortgage-backed securities |
366 | 3.81 | % | 113,988 | 4.45 | % | 3,821 | 5.42 | % | — | — | 118,175 | 4.48 | % | ||||||||||||||||
| State & political subdivisions (1) |
3,323 | 7.93 | % | 14,962 | 6.10 | % | 26,062 | 5.86 | % | 9,366 | 6.21 | % | 53,713 | 6.12 | % | |||||||||||||||
| Equity securities (2) |
— | — | — | — | — | — | 9 | 4.63 | % | 9 | 4.63 | % | ||||||||||||||||||
| Total investment securities |
$ | 7,163 | $ | 143,156 | $ | 30,578 | $ | 9,375 | $ | 190,272 | ||||||||||||||||||||
| (1) | Yields are not adjusted for the tax benefits of non taxable income |
| (2) | Equity securities have no stated maturity but have been added to the after ten years, for ease of review. |
Cash and Due From Banks
Cash on hand and balances due from correspondent banks totaled $53 million at the end of 2006 and $50 million at the end of 2005. At December 31, 2006, cash and due from banks comprised 4% of total assets, compared to 5% at December 31, 2005. These balances fluctuate frequently and by large amounts depending on the status of cash items in process of collection and cash on hand, thus period-end balances are not optimal indicators of trends in cash and due from banks. Annual average balances provide a much more appropriate gauge. The average balance for 2006 was $40 million and for 2005 it was $38 million, an increase consistent with the addition of branches in late 2005 and early 2006. This balance is expected to increase further as we add more branches in the future.
Premises and Equipment
Premises and equipment are stated at cost, less accumulated depreciation and amortization. Depreciation is charged to income over the estimated useful lives of the assets and leasehold improvements are amortized over the terms of the related lease, or the estimated useful lives of the improvements, whichever is shorter. Depreciation and amortization included in occupancy and equipment expense was $3.1 million for the year ended December 31, 2006 as compared to $3.0 million during 2005. Depreciation on equipment leased to others is reflected in other operating costs. The following premises and equipment table reflects the balances by major category of fixed assets:
| As of December 31, | |||||||||||||||||||||||||||
| 2006 | 2005 | 2004 | |||||||||||||||||||||||||
| Premises & Equipment (dollars in thousands) |
Cost | Accumulated Depr and Amort |
Net Book Value |
Cost | Accumulated Depr and Amort |
Net Book Value |
Cost | Accumulated Depr and Amort |
Net Book Value | ||||||||||||||||||
| Land |
$ | 2,054 | $ | — | $ | 2,054 | $ | 2,054 | $ | — | $ | 2,054 | $ | 2,045 | $ | — | $ | 2,045 | |||||||||
| Buildings |
$ | 11,189 | $ | 3,929 | $ | 7,260 | $ | 10,287 | $ | 3,543 | $ | 6,744 | $ | 9,875 | $ | 3,177 | $ | 6,698 | |||||||||
| Leasehold Improvements |
$ | 5,336 | $ | 1,591 | $ | 3,745 | $ | 4,847 | $ | 1,568 | $ | 3,279 | $ | 3,675 | $ | 1,332 | $ | 2,343 | |||||||||
| Construction in progress |
$ | 443 | $ | — | $ | 443 | $ | 416 | $ | — | $ | 416 | $ | 11 | $ | — | $ | 11 | |||||||||
| Furniture and Equipment |
$ | 19,312 | $ | 14,836 | $ | 4,476 | $ | 18,949 | $ | 13,387 | $ | 5,562 | $ | 17,881 | $ | 11,247 | $ | 6,634 | |||||||||
| Total |
$ | 38,334 | $ | 20,356 | $ | 17,978 | $ | 36,553 | $ | 18,498 | $ | 18,055 | $ | 33,487 | $ | 15,756 | $ | 17,731 | |||||||||
The net book value of the Company’s premises and equipment declined by $77,000 in 2005, since the net increase in accumulated depreciation more than offset capitalized costs associated with building and outfitting the new Bakersfield Riverlakes branch. The net book value of the Company’s aggregate premises and equipment was 1.5% of total assets at December 31, 2006, 1.7% at December 31, 2005, and 1.8% at December 31, 2004.
Other Assets
Other assets increased by $13.8 million, or 26%, during 2006, and were about 5% of total assets at the end of both 2006 and 2005. The balance increase in 2006 is primarily attributable to the following: the net cash surrender value of BOLI increased by $6.8 million, due to an additional $6.0 million investment made in December 2006 plus earnings for the year; our investment in tax credit funds increased by $1.1 million, due to an additional $2.0 million commitment less pass-through losses recognized during the year; our restricted stock balance increased $4.9 million,
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due to an increase in FHLB stock purchased in conjunction with a higher level of FHLB borrowings, less the payoff of the remaining book value of our investment in Diversified Holdings Corporation; and accrued interest receivable increased $1.6 million due to a higher balance of loans and higher interest rates.
As noted above, the Company holds certain equity investments that are not readily marketable securities and thus are classified as “other assets” on the Company’s balance sheet. These include investments in Pacific Coast Bankers Bancshares, California Economic Development Lending Initiative, and the FHLB. At the end of 2005 that list included Diversified Holdings Corporation (“DHC”), but we received a payout during 2006 from the proceeds of the sale of the operating units of DHC which was applied against the remaining book value of our investment. We anticipate an additional final payout of approximately $100,000 in 2007 to be booked as a gain, however no assurance can be given that this money will be received. At December 31, 2006, the largest of the referenced investments is the Company’s $9.8 million investment in FHLB stock. This investment fluctuates from time to time based on the Company’s borrowing activity at the Federal Home Loan Bank, and as noted earlier increased in 2006 due to an increase in short-term borrowings used to fund loan growth.
The other assets category also includes low-income housing tax credit funds, which lower the Company’s tax liability through direct tax credits as well as partnership operating losses. Pass-through partnership losses from tax credit funds are charged against the Company’s investment in such funds, thus the investment has been written down from an aggregate total of $15.5 million to $11.8 million at December 31, 2006. Even taking losses into consideration and assuming no gain upon disposition, the estimated tax-equivalent return on most of these investments over their expected 15-year life is around 11%, although no guarantee can be provided that this level of return will ultimately be realized.
As noted, the other assets category includes an aggregate $26.5 million investment in bank-owned life insurance at December 31, 2006. BOLI is an insurance policy with a single premium paid at policy commencement. Its initial net cash surrender value is equivalent to the premium paid, and it adds income through non-taxable increases in its cash surrender value, net of the cost of insurance, plus any death benefits ultimately received by the Company. The expenses of certain benefit plans are offset by BOLI income.
At December 31, 2006, a $5.0 million net deferred tax asset is also an element of the Company’s other assets. Most of the Company’s temporary differences between book and taxable income and expenses involve recognizing more expense in its financial statements than it has been allowed to deduct for current-period taxes; therefore, the Company’s deferred tax assets typically exceeds its deferred tax liabilities. The net deferred tax asset is primarily due to temporary book/tax differences in the reported allowance for loan losses plus deferred compensation, net of deferred liabilities comprised mainly of fixed asset depreciation differences and deferred loan origination costs. Management has evaluated all deferred tax assets, and has no reason to believe that either the quality of the deferred tax assets or the Company’s future taxable income potential would preclude full realization of all amounts in future years.
Deposits
Information concerning the average balance and average rates paid on deposits by deposit type for the past three fiscal years is contained in the Distribution, Rate, and Yield table located in the previous section on Results of Operations–Net Interest Income and Net Interest Margin. The composition and cost of the Company’s deposit base are important factors in analyzing the Company’s net interest margin and balance sheet liquidity characteristics, both of which are discussed in greater detail in other sections herein. Our net interest margin improves when growth in deposits can be concentrated in historically lower-cost balances such as non-interest-bearing demand, NOW, savings and money market deposit accounts. The Company’s liquidity is impacted by the volatility of deposits or other funding instruments, or in other words by the propensity of that money to leave the institution for rate-related or other reasons. Potentially, the most volatile deposits in a financial institution are jumbo certificates of deposit, meaning time deposits with balances that equal or exceed $100,000, as customers with balances of that magnitude are typically more rate-sensitive than customers with smaller balances. The Company’s community-oriented deposit gathering activities, however, seem to have engendered a base of local customers who tend to display more brand loyalty and thus are less likely to leave the Company than might otherwise be expected.
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The Company’s total deposits grew by $53 million, or 6% in 2006, due primarily to a $45 million increase in wholesale-sourced brokered time deposits. Among core deposit categories, non-interest demand deposits dropped by $1 million, or 1%, falling to 32% of total deposits at the end of 2006 from 35% at the end of 2005. Furthermore, relatively low-cost NOW accounts fell by $4 million, or 6%, and savings account balances declined by $9 million, or 12%. Money market accounts, however, increased by $8 million, or 8%, and time deposits under $100,000 increased by $20 million, or 18%. Our increase in money market accounts is the result of a new money market sweep account for businesses that pays relatively aggressive rates, and much of this money was transferred from lower-cost deposits or customer repurchase agreement money already with the Company. Nevertheless, we view this new account as a defensive product that can help us retain deposits and compete more effectively for new commercial deposits. Much of the increase in time deposits under $100,000 also represents movement from lower-cost deposits. While our core deposit accounts increased in number to 60,051 at the end of 2006 from 57,949 at the end of 2005, the average balance per core deposit account declined slightly to about $10,900 at the end of 2006 from $11,000 at the end of 2005.
Non-core deposit changes include the aforementioned increase in brokered deposits, and a $6 million decline in other jumbo time deposits (of $100,000 or greater). The Company had a total of $80 million in wholesale brokered deposits on its books at December 31, 2006 and $35 million at year-end 2005. Maturities of these deposits are staggered over the next six months, and it is our intention to replace them with internally-generated branch deposits when possible.
The shift from lower-cost to higher-cost core deposit balances and overall stagnation in deposit growth experienced by the Company during 2006 appear to be typical for many financial institutions around the country, based on FDIC banking industry reports and other institution-specific data. These changes are likely due in part to the systemic migration of core deposit balances into higher-yielding alternatives, including equity markets, and could also be the result of fundamental changes taking place in global payments systems. Competition has intensified for the remaining deposits. To help address the decline in lower-cost core deposit balances, management has supplemented the Company’s deposit products to include remote deposit capture capabilities, modified retail deposit offerings to better align them with market demand, and is focused on intensifying marketing and cross-sell efforts. An officer incentive program specifically targeting deposits has also been implemented.
The scheduled maturity distribution of the Company’s time deposits as of December 31, 2006 was as follows:
| As of December 31, 2006 | ||||||||||||||||||
| Deposit Maturity Distribution (dollars in thousands) |
Three months or less |
Three to six months |
Six to twelve |
One to three years |
Over three Years |
Total | ||||||||||||
| Time Certificates of Deposits < $100,000 |
$ | 63,517 | $ | 37,791 | $ | 19,249 | $ | 6,689 | $ | 1,378 | $ | 128,624 | ||||||
| Other Time Deposits > $100,000 |
$ | 135,458 | $ | 57,816 | $ | 16,597 | $ | 5,782 | $ | 358 | $ | 216,011 | ||||||
| TOTAL |
$ | 198,975 | $ | 95,607 | $ | 35,846 | $ | 12,471 | $ | 1,736 | $ | 344,635 | ||||||
In addition to deposit liabilities obtained in local markets, the Company provides a cash management product to its commercial business customers. This product group is categorized as a non-deposit “sweep” account. At December 31, 2006, the Company’s balance sheet includes $26 million in repurchase agreements in short-term borrowings (see next section), secured by pledged investments held segregated from the Company’s securities portfolio, that represent such sweep accounts. At December 31, 2005, the Company’s financial statements reflected approximately $27 million in repurchase agreements. Due to their overnight nature and because they are collateralized, the cost of these sweep accounts has generally been significantly lower than the Company’s interest rates for longer-term non-collateralized funds. For those companies not requiring collateralization of their deposits, we anticipate further migration from this category into the money market sweep account.
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Other Borrowings
The Company utilizes other short-term borrowings to temporarily fund loan growth when customer deposit growth has not kept pace with increases in outstanding loan balances. In addition, short-term borrowings may be used to purchase additional investments, or when additional liquidity is required to support higher customer cash utilization. Short-term borrowings principally include overnight fed funds purchased, advances from the Federal Home Loan Bank of San Francisco (FHLB), and securities sold under repurchase agreements which were described more fully in the previous section. The details of these borrowings for the years 2006, 2005, and 2004 are presented below:
| Short-term Borrowings |
2006 | 2005 | 2004 | |||||||||
| Repurchase Agreements (dollars in thousands) |
||||||||||||
| Balance at December 31 |
$ | 26,003 | $ | 26,791 | $ | 24,187 | ||||||
| Average amount outstanding |
$ | 24,281 | $ | 28,772 | $ | 23,782 | ||||||
| Maximum amount outstanding at any month end |
$ | 29,541 | $ | 31,038 | $ | 27,394 | ||||||
| Average interest rate for the year |
0.66 | % | 0.38 | % | 0.32 | % | ||||||
| Fed funds purchased (dollars in thousands) |
||||||||||||
| Balance at December 31 |
$ | 25,000 | $ | — | $ | — | ||||||
| Average amount outstanding |
$ | 13,235 | $ | 690 | $ | 1,003 | ||||||
| Maximum amount outstanding at any month end |
$ | 25,000 | $ | 10,600 | $ | 5,900 | ||||||
| Average interest rate for the year |
5.10 | % | 4.06 | % | 1.10 | % | ||||||
| Short Term Borrowings (dollars in thousands) |
||||||||||||
| Balance at December 31 |
$ | 131,400 | $ | 41,070 | $ | 43,800 | ||||||
| Average amount outstanding |
$ | 92,106 | $ | 25,357 | $ | 18,038 | ||||||
| Maximum amount outstanding at any month end |
$ | 171,300 | $ | 56,900 | $ | 43,800 | ||||||
| Average interest rate for the year |
4.68 | % | 3.25 | % | 1.57 | % | ||||||
In addition to short-term borrowings, the Company had $27 million in long-term borrowings on its balance sheet at December 31, 2006, down from $46 million at December 31, 2005. The long-term borrowings represent secured advances from the FHLB pursuant to the leverage strategy, and declined due to planned leverage strategy runoff. Original maturities on these borrowings ranged from one year up to five years.
Capital Resources
At December 31, 2006, the Company had total shareholders’ equity of $90.4 million, comprised of $16.1 million in common stock, $75.9 million in retained earnings, and a $1.6 million accumulated other comprehensive loss. Total shareholders equity at the end of 2005 was $78.8 million. The $7.5 million increase in retained earnings in 2006 represents net income of $19.2 million, less $5.3 million in dividends paid and less the allocation to retained earnings of much of the cost of stock repurchases executed during the year. While the retention of earnings has been the Company’s main source of capital since 1982, the Company currently has a total of $30 million in trust preferred securities outstanding, issued through its unconsolidated wholly-owned subsidiaries, Sierra Statutory Trust II and Sierra Capital Trust III. As noted previously, the Company’s first trust preferred issuance was refinanced during 2006, and for the overlap period, which constituted most of the latter half of the year, the total outstanding was $45
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million. Trust preferred proceeds are generally considered to be Tier 1 or Tier 2 capital for regulatory purposes, but long-term debt in accordance with generally accepted accounting principles. However, no assurance can be given that trust preferred securities will continue to be treated as Tier 1 capital in the future.
The Company paid cash dividends totaling $5.3 million, or $0.54 per share in 2006, and $4.4 million, or $0.45 per share in 2005, representing 33% of the prior year’s earnings for both 2006 and 2005. The Company anticipates paying future dividends of around 30% to 35% of the prior year’s net earnings, which is within the range of typical peer payout ratios. However, no assurance can be given that earnings and/or growth expectations in any given year will justify the payment of such a dividend.
The Company uses a variety of measures to evaluate capital adequacy. Management reviews various capital measurements on a regular basis and takes appropriate action to ensure that such measurements are within established internal and external guidelines. The external guidelines, which are issued by the Federal Reserve Board and the FDIC, establish a risk-adjusted ratio relating capital to different categories of assets and off-balance sheet exposures. There are two categories of capital under the Federal Reserve Board and FDIC guidelines: Tier 1 and Tier 2 Capital. Our Tier 1 Capital currently includes common shareholders’ equity and the proceeds from the issuance of trust preferred securities (trust preferred securities are counted only up to a maximum of 25% of Tier 1 capital), less goodwill and certain other deductions, notably the unrealized net gains or losses (after tax adjustments) on securities available for sale, which are carried at fair market value. Our Tier 2 Capital includes preferred stock, the amount of trust preferred securities not includible in Tier 1 Capital, and the allowance for loan losses, subject to certain limitations. (For a more detailed definition, see “Item 1, Business-Supervision and Regulation – Capital Adequacy Requirements” herein.)
At December 31, 2006, the Company had a total capital to risk-weighted assets ratio of 12.98%, a Tier 1 risk based capital ratio of 11.77%, and a leverage ratio of 9.92%. Despite substantial growth in risk-adjusted assets, these are only slightly lower than previous year-end ratios of 13.50% for total capital to risk-weighted assets, 12.01% for Tier 1 to risk-weighted assets, and 9.87% for leverage. Note 13 of the Notes to the Consolidated Financial Statements provides more detailed information concerning the Company’s capital amounts and ratios. At December 31, 2006, on a stand-alone basis, the Bank had a total risk-based capital ratio of 12.49%, a Tier 1 risk-based capital ratio of 11.31%, and a leverage capital ratio of 9.53%. As of the end of 2006, both the Company and the Bank were considered to be “well capitalized” by regulatory standards. We do not foresee any circumstances that would cause either the Company or the Bank to be less than “well capitalized”, although no assurance can be given that this will not occur.
Liquidity and Market Risk Management
Liquidity
Liquidity refers to the Company’s ability to maintain cash flows sufficient to fund operations, and to meet obligations and other commitments in a timely and cost-effective fashion. At various times the Company requires funds to meet short-term cash requirements brought about by loan growth or deposit outflows, the purchase of assets, or liability repayments. To manage liquidity needs properly, cash inflows must be timed to coincide with anticipated outflows, or sufficient liquidity resources must be available to meet varying demands. The Company manages liquidity in such a fashion as to be able to meet unexpected sudden changes in levels of its assets or deposit liabilities without maintaining excessive amounts of on-balance sheet liquidity. Over-abundant balance sheet liquidity can negatively impact the interest margin.
An integral part of the Company’s ability to manage its liquidity position appropriately is the Company’s large base of core deposits, which are generated by offering traditional banking services in the communities in its service area and which have, historically, been a very stable source of funds. In addition to core deposits, the Company has the ability to raise deposits through various deposit brokers if required for liquidity purposes. The Company’s net loan to deposit ratio increased significantly to 100.5% at the end of 2006 from 89.5% at the end of 2005, due to a loan growth rate that exceeded the rate of deposit growth during 2006.
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We also monitor the Company’s liquidity position with a “liquidity ratio” defined as net cash, non-pledged investment securities, and other marketable assets, divided by total deposits and short-term liabilities minus liabilities secured by investments or other marketable assets. This ratio was 17.2% at the end of December 2006, and 18.5% at the end of December 2005, well within the policy guideline of “over 10%”. Because most of the growth in loans in 2006 was funded with FHLB borrowings and brokered deposits, other liquidity ratios tracked by the Company, such as average loans to deposits and net non-core funding dependence, have been slightly outside of policy guidelines for several months. We continue to watch these ratios closely, and expect that as loan growth slows in 2007 and deposit growth increases they will come back within guidelines. Even given our current status, though, our true liquidity has not been impaired, and we have the ability to generate sufficient cash to meet all of our financial obligations and continue to grow assets as planned. However, it is also possible that if deposits do not increase as expected and if other borrowings reach uncomfortable levels, we could take other measures such as the sale of investments or loans to generate liquidity, which would slow our growth or even reduce the size of our balance sheet.
The unpledged portion of the Company’s investment portfolio is an integral component of liquidity management due to the relative ease with which many bonds can be sold. There were $24 million in unpledged marketable investments, and $17 million more in pledged securities in excess of actual needs, at the end of 2006 that could be sold for liquidity purposes if necessary. Management is of the opinion that its investments and other potentially liquid assets, along with other standby funding sources it has arranged, are more than sufficient to meet the Company’s current and anticipated short-term liquidity needs. Along with available investment balances, sources of balance sheet liquidity include $53 million in cash and due from banks, $20 million in the guaranteed portion of SBA loans, and $27 million in the net cash surrender value of BOLI. Standby funding sources include a formal secured borrowing line with the Federal Home Loan Bank that has availability of $73 million based on the current level of pledged real estate assets, informal unsecured short-term liquidity lines for overnight fed funds with certain correspondent banks totaling $63 million, and a $2.2 million secured line at the Federal Reserve Discount Window.
Interest Rate Risk Management
Market risk arises from changes in interest rates, exchange rates, commodity prices and equity prices. The Company’s market risk exposure is primarily that of interest rate risk, and it has established policies and procedures to monitor and limit earnings and balance sheet exposure to changes in interest rates. The Company does not engage in the trading of financial instruments, nor does the Company have exposure to currency exchange rates.
The principal objective of interest rate risk management (often referred to as “asset/liability management”) is to manage the financial components of the Company’s balance sheet in a manner that will optimize the risk/reward equation for earnings and capital in relation to changing interest rates. To identify areas of potential exposure to rate changes, the Company performs an earnings simulation analysis and a market value of portfolio equity calculation on a monthly basis. This identifies more dynamic interest rate risk exposures than those apparent in standard re-pricing gap analyses.
The Company uses Sendero modeling software for asset/liability management in order to simulate the effects of potential interest rate changes on the Company’s net interest margin, and to calculate the estimated fair values of the Company’s financial instruments under different interest rate scenarios. The program imports current balances, interest rates, maturity dates and repricing information for individual financial instruments, and incorporates assumptions on the characteristics of embedded options along with pricing and duration for new volumes to project the effects of a given interest rate change on the Company’s interest income and interest expense. Rate scenarios consisting of key rate and yield curve projections are run against the Company’s investment, loan, deposit and borrowed funds portfolios. These rate projections can be shocked (an immediate and parallel change in all base rates, up or down), ramped (an incremental increase or decrease in rates over a specified time period), economic (based on current trends and econometric models) or stable (unchanged from current actual levels).
The Company uses seven standard interest rate scenarios in conducting its simulations, namely “stable,” upward shocks of 100, 200 and 300 basis points, and downward shocks of 100, 200, and 300 basis points. Our policy is to limit any projected decline in net interest income relative to the stable rate scenario for the next 12 months to no more than 5% based on a 100 basis point (b.p.) shock, no more than 10% based on a 200 b.p. shock, and no more than 15% for a 300 b.p. shock in interest rates. As of December 31, 2006, the Company had the following estimated net interest income sensitivity profile:
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| Immediate Change in Rate | ||||||||||||||||||||||||
| -300 b.p. | -200 b.p. | -100 b.p. | +100 b.p. | +200 b.p. | +300 b.p. | |||||||||||||||||||
| Change in Net Int. Inc. (in $000’s) |
-$ | 2,382 | -$ | 1,332 | -$ | 374 | $ | 211 | $ | 257 | $ | 212 | ||||||||||||
| % Change |
-4.02 | % | -2.25 | % | -0.63 | % | +0.36 | % | +0.43 | % | +0.36 | % | ||||||||||||
The above profile illustrates that if there were an immediate and sustained downward adjustment of 200 basis points in interest rates, all else being equal, net interest income over the next twelve months would likely be $1.3 million, or 2.25%, lower than net interest income under a stable rate scenario. By the same token, if there were an immediate increase of 200 basis points in interest rates, the Company’s net interest income would likely be $257,000, or 0.43%, higher than net interest income in a flat rate scenario. According to these simulations the Company is slightly asset sensitive over a one-year time frame, meaning that interest-earning assets will re-price more quickly than interest-bearing liabilities and, all else being equal, the Company’s net interest margin will be lower when short-term rates are falling and higher when rates are rising. This is supported by fact the Company has, in the past, seen erosion in its interest margin when rates have declined but has benefited from rising rates. Our asset sensitivity can be explained in part by fact that well over half of our loan portfolio consists of variable-rate and adjustable-rate loans. On the other side of the balance sheet, we have a relatively large level of interest-free demand deposits and other non-maturity deposits that are not extremely sensitive to interest rate changes.
The changes in net interest income under rising and declining rate scenarios are typically expected to bear more of a linear relationship. The exposure to declining rates is disproportionate in these simulations, however, because some of the Company’s variable deposit rates are still relatively close to a natural floor of zero. If rates were to move down to a significant degree certain deposit rates would hit this floor, but earning asset yields would continue to fall and our net interest margin would likely experience significant compression. This effect is exacerbated by the fact that prepayments on fixed-rate loans tend to increase as rates decline. Our interest rate risk profile has changed somewhat over the course of the past year as we have added more long-term fixed-rate loans, and our exposure to declining rates has been mitigated to some extent. This has been enhanced by disproportionate growth in our rate-sensitive liabilities, which become less costly and augment net interest income as rates decline.
The economic (or “fair”) value of financial instruments on the Company’s balance sheet will also vary under the interest rate scenarios previously discussed. Economic values for financial instruments are estimated by discounting projected cash flows (principal and interest) at current replacement rates for each account type, while the fair value of non-financial accounts is assumed to equal book value and does not vary with interest rate fluctuations. An economic value simulation is a static measure for balance sheet accounts at a given point in time, but this measurement can change substantially over time as the characteristics of the Company’s balance sheet evolve and as interest rate and yield curve assumptions are updated.
The amount of change in economic value under different interest rate scenarios is dependent upon the characteristics of each class of financial instrument, including the stated interest rate or spread relative to current market rates or spreads, the likelihood of prepayment, whether the rate is fixed or floating, and the maturity date of the instrument. As a general rule, fixed-rate financial assets become more valuable in declining rate scenarios and less valuable in rising rate scenarios, while fixed-rate financial liabilities gain value as interest rates rise and lose value as interest rates decline. The longer the maturity of the financial instrument, the greater the impact a given rate change will have on its value. In our economic value simulations, estimated prepayments are factored in for financial instruments with stated maturity dates, and decay rates for non-maturity deposits are also projected based on management’s best estimates. We have found that model results are highly sensitive to changes in the assumed decay rate for non-maturity deposits, in particular.
The economic value of equity (EVE) is calculated by subtracting the estimated fair value of liabilities from the estimated fair value of assets. The table below shows estimated changes in the Company’s EVE under different interest rate scenarios relative to a base case of current interest rates:
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| Immediate Change in Rate | |||||||||||||||||||||||
| -300 b.p. | -200 b.p. | -100 b.p. | +100 b.p. | +200 b.p. | +300 b.p. | ||||||||||||||||||
| Change in EVE (in $000’s) |
$ | 8,841 | $ | 6,918 | $ | 5,178 | -$ | 7,582 | -$ | 17,367 | -$ | 27,177 | |||||||||||
| % Change |
+4.25 | % | +3.33 | % | +2.49 | % | -3.65 | -8.36 | % | -13.08 | % | ||||||||||||
The drop in EVE as rates increase is the reverse of the positive slope apparent in the Company’s net interest income simulations, due primarily to the fact that $524 million in non-maturity deposits are assumed to run off at the rate of 10% per year. In contrast, our net interest income simulations incorporate growth rather than run-off for non-maturity deposits. If a higher deposit decay rate is used for EVE simulations the decline becomes more severe, while the slope conforms more closely to that of our net interest income simulations if non-maturity deposits do not run off. Under declining rates, a floor of zero (or slightly above zero) for the discount rate on variable rate deposits and other liabilities, and increased principal prepayments and calls on investment securities and fixed rate loans, partially offset the increase in the value of fixed-rate loans. During 2006, the addition of fixed-rate loans has caused the negative slope in rising rate scenarios to become steeper, and the slope in declining rate scenarios to move from negative to slightly positive.
| ITEM 7A. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
The information concerning quantitative and qualitative disclosures of market risk called for by Item 305 of Regulation S-K is included as part of Item 7 above. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Market Risk Management”.
| ITEM 8. | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA |
The following financial statements and independent auditors’ reports listed below are included herein:
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Report of Independent Registered Public Accounting Firm
Board of Directors
Sierra Bancorp
Porterville, California
We have audited the accompanying consolidated balance sheets of Sierra Bancorp and Subsidiary (the “Company”) as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sierra Bancorp and Subsidiary as of December 31, 2006 and 2005, and the results of its operations, changes in its stockholders’ equity, and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Sierra Bancorp and Subsidiary internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 15, 2007 expressed an unqualified opinion thereon.
| /s/ Vavrinek, Trine, Day & Co., LLP |
| Rancho Cucamonga, California |
| March 15, 2007 |
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SIERRA BANCORP AND SUBSIDIARY
December 31, 2006 and 2005
(Dollars in thousands)
| 2006 | 2005 | |||||||
| ASSETS |
||||||||
| Cash and due from banks |
$ | 52,645 | $ | 49,802 | ||||
| Federal funds sold |
6,290 | — | ||||||
| Interest-bearing deposits in banks |
80 | 345 | ||||||
| Cash and cash equivalents |
59,015 | 50,147 | ||||||
| Investment securities available-for-sale |
190,272 | 193,676 | ||||||
| Loans and leases, net of allowance for loan and lease losses of $11,579 in 2006 and $9,330 in 2005 |
872,811 | 729,780 | ||||||
| Premises and equipment, net |
17,978 | 18,055 | ||||||
| Operating leases, net |
2,818 | 2,113 | ||||||
| Other real estate |
— | 533 | ||||||
| Goodwill |
5,544 | 5,544 | ||||||
| Other assets |
66,636 | 52,838 | ||||||
| Total assets |
$ | 1,215,074 | $ | 1,052,686 | ||||
| LIABILITIES AND SHAREHOLDERS’ EQUITY |
||||||||
| Deposits: |
||||||||
| Non-interest bearing |
$ | 281,024 | $ | 282,451 | ||||
| Interest bearing |
587,421 | 533,220 | ||||||
| Total deposits |
868,445 | 815,671 | ||||||
| Short-term borrowings |
182,403 | 67,861 | ||||||
| Long-term borrowings |
27,000 | 46,000 | ||||||
| Subordinated debentures |
30,928 | 30,928 | ||||||
| Other liabilities |
15,927 | 13,463 | ||||||
| Total liabilities |
1,124,703 | 973,923 | ||||||
| Commitments and contingencies (Note 11) |
||||||||
| Shareholders’ equity |
||||||||
| Common stock, no par value; 24,000,000 shares authorized; 9,749,913 and 9,723,320 shares issued and outstanding in 2006 and 2005, respectively |
16,102 | 12,221 | ||||||
| Retained earnings |
75,928 | 68,382 | ||||||
| Accumulated other comprehensive loss, net of taxes of $1,202 in 2006 and $1,286 in 2005 |
(1,659 | ) | (1,840 | ) | ||||
| Total shareholders’ equity |
90,371 | 78,763 | ||||||
| Total liabilities and shareholders’ equity |
$ | 1,215,074 | $ | 1,052,686 | ||||
The accompanying notes are an integral part of these consolidated financial statements.
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SIERRA BANCORP AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
For the Years Ended December 31, 2006, 2005 and 2004
(Dollars in thousands, except per share data)
| 2006 | 2005 | 2004 | ||||||||
| Interest income: |
||||||||||
| Interest and fees on loans and leases |
$ | 72,410 | $ | 55,966 | $ | 45,600 | ||||
| Interest on investment securities: |
||||||||||
| Taxable |
6,294 | 6,526 | 5,042 | |||||||
| Exempt from federal tax |
2,040 | 1,507 | 1,312 | |||||||
| Interest on Federal funds sold and interest-bearing deposits |
34 | 136 | 54 | |||||||
| Total interest income |
80,778 | 64,135 | 52,008 | |||||||
| Interest expense: |
||||||||||
| Interest on deposits |
15,808 | 8,684 | 5,411 | |||||||
| Interest on borrowings |
6,118 | 2,463 | 1,675 | |||||||
| Interest on subordinated debentures |
3,205 | 2,185 | 1,410 | |||||||