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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File Number 2-91196
NORTHERN EMPIRE BANCSHARES
-----------------------------------------------------
(Exact name of registrant as specified in its charter)
California 94-2830529
- --------------------------------------------- ------------------
(State or other jurisdiction of incorporation (I.R.S. Employer
or organization) Identification No.)
801 Fourth Street, Santa Rosa, California 95404
----------------------------------------- ---------
(Address of principal executive offices) (Zip code)
707-579-2265
--------------------------------------------------
Registrant's telephone number, including area code)
NONE
---------------------------------------------------------------
(Former name, former address and former fiscal year, if changed
since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act
of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.
Yes X No
APPLICABLE ONLY TO CORPORATE ISSUERS
Indicate the number of shares outstanding of each of the issuer's classes
of common stock, as of the latest practicable date.
Title of class: Common Stock, no par value. Outstanding shares as of
July 15, 2002: 4,177,547
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NORTHERN EMPIRE BANCSHARES AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(Unaudited)
(dollars in thousands)
ASSETS
June 30, December 31,
2002 2001
------- -----------
Cash and equivalents:
Cash and due from banks $20,507 $16,726
Federal funds sold 83,624 65,516
Total cash and equivalents 104,131 82,242
-------- --------
Interest-bearing deposits in banks 298 298
Investment securities available-for-sale 646 998
Federal Home Loan Bank stock, at cost 1,840 599
Federal Reserve Bank stock, at cost 164 163
Loans receivable, net 528,771 466,529
Leasehold improvements and equipment, net 1,016 1,037
Accrued interest receivable and other assets 9,349 9,138
-------- --------
Total assets $646,215 $561,004
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Deposits $557,010 $502,137
Accrued interest payable and
other liabilities 3,423 2,768
FHLB advances 36,790 11,802
-------- --------
Total liabilities 597,223 516,707
-------- --------
Shareholders' equity:
Preferred stock, no par value;
authorized, 10,000,000 shares;
none issued or outstanding
Common stock, no par value;
authorized, 20,000,000 shares;
shares issued and outstanding,
4,177,547 at June 30, 2002 and
4,171,926 2001 27,495 21,946
Additional paid-in capital 786 786
Accumulated other comprehensive income (loss) 3 (1)
Retained earnings 20,708 21,566
-------- --------
Total shareholders' equity 48,992 44,297
-------- --------
Total liabilities and shareholders' equity $646,215 $561,004
======== ========
See Notes to Consolidated Financial Statements
NORTHERN EMPIRE BANCSHARES AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
For the three and six months ended June 30, 2002 and 2001
(Unaudited)
(dollars in thousands, except per share data)
Three Months Ended Six Months Ended
June 30, June 30,
2002 2001 2002 2001
------- ------- -------- -------
Interest income:
Loans $9,950 $11,165 $19,390 $21,970
Federal funds sold and
investment securities 277 456 520 983
------- ------- -------- -------
Total interest income 10,227 11,621 19,910 22,953
Interest expense 3,812 5,513 7,483 11,024
------- ------- -------- -------
Net interest income before
provision for loan losses 6,415 6,108 12,427 11,929
Provision for loan losses 150 240 300 480
------- ------- -------- -------
Net interest income after
provision for loan losses 6,265 5,868 12,127 11,449
------- ------- -------- -------
Other income:
Service charges on deposits 120 101 259 204
Gain on sale of loans 246 164 463 346
Other 166 195 328 361
------- ------- -------- -------
Total other income 532 460 1,050 911
------- ------- -------- -------
Other expenses:
Salaries and employee benefits 1,699 1,485 3,173 3,003
Occupancy 265 227 522 449
Equipment 153 148 298 291
Advertising and
business development 125 122 247 232
Outside customer services 88 106 202 226
Director and shareholder expenses 98 69 177 145
Deposit and other insurance 80 74 160 146
Professional fees 75 28 129 97
Other 241 276 476 522
------- ------- -------- -------
Total other expenses 2,824 2,535 5,384 5,111
------- ------- -------- -------
Income before income taxes 3,973 3,793 7,793 7,249
Provision for income taxes 1,619 1,549 3,163 2,926
------- ------- -------- -------
Net income $2,354 $2,244 $4,630 $4,323
======= ======= ======== =======
Earnings per common share $ 0.56 $ 0.54 $ 1.11 $ 1.04
======= ======= ======== =======
Earnings per common share
assuming dilution $ 0.49 $ 0.50 $ 0.98 $ 0.96
======= ======= ======== =======
See notes to Consolidated Financial Statements
NORTHERN EMPIRE BANCSHARES AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
For the six months ended June 30, 2002 and 2001
(Unaudited)
(dollars in thousands)
2002 2001
-------- -------
Cash flows from operating activities:
Net income $ 4,630 $ 4,323
Adjustments to reconcile net income to net
cash provided by operating activities:
Provision for loan losses and OREO losses 300 480
Depreciation, amortization and accretion 216 210
FHLB stock dividends (12) (17)
Change in deferred loan fees and discounts (332) (471)
Change in deferred income taxes 120 (139)
Increase in interest receivable and other assets (331) (42)
Increase in accrued interest payable and
other liabilities 655 105
-------- -------
Net cash provided by in operating activities 5,246 4,449
-------- -------
Cash flows from investing activities:
Purchase of restricted securities (1,238) (4)
Maturities of available for sale securities 360 977
Redemption of restricted securities 1
Net increase in loans receivable (62,210) (27,636)
Purchase of leasehold improvements and
equipment, net (195) (258)
-------- -------
Net cash used in investing activities (63,283) (26,920)
-------- -------
Cash flows from financing activities:
Net increase in deposits 54,873 29,148
Net increase (decrease) in FHLB advances 24,988 (13)
Payment of cash dividends (6) (4)
Stock options exercised 71 50
-------- -------
Net cash provided by financing activities 79,926 29,181
-------- -------
Net increase in cash and cash equivalents 21,889 6,710
Cash and cash equivalents at beginning of year 82,242 49,527
-------- -------
Cash and cash equivalents at end of period $104,131 $56,237
======== =======
Supplemental cash flow information:
Interest paid $ 7,435 $11,158
======== =======
Income taxes paid $ 2,430 $ 2,714
======== =======
See notes to Consolidated Financial Statements
Northern Empire Bancshares and Subsidiary
Notes to Consolidated Financial Statements
June 30, 2002
Note 1 - Basis of Presentation
In the opinion of Management, the unaudited interim consolidated financial
statements contain all adjustments of a normal recurring nature, which are
necessary to present fairly the financial condition of Northern Empire
Bancshares (the "Corporation") and Subsidiary at June 30, 2002 and the
results of operations for the three and six months then ended.
Certain information and footnote disclosures presented in the Corporation's
annual consolidated financial statements are not included in these interim
financial statements. Accordingly, the accompanying unaudited interim
consolidated financial statements should be read in conjunction with the
consolidated financial statements and notes thereto included in the
Corporation's 2001 Annual Report on Form 10-K. The results of operations
for the three and six months ended June 30, 2002 are not necessarily
indicative of the operating results through December 31, 2002.
Note 2 - Net Income per Common and Common Equivalent Share
Basic earnings per share (EPS) is computed by dividing income available to
common shareholders by the weighted average number of common shares outstanding
during the period. Diluted EPS is computed by dividing diluted income available
to common shareholders by the weighted average number of common shares and
common equivalent shares outstanding which include dilutive stock options. The
computation of common stock equivalent shares is based on the weighted average
market price of the Corporation's common stock throughout the period. Prior year
common stock has been adjusted for the impact of the 5% stock dividend declared
on March 26, 2002. The Corporation's pertinent EPS data is as follows:
For the three months ended For the three months ended
June 30, 2002 June 30, 2001
------------------------------ ------------------------------
Per Per
Income/ Shares/ Share Income/ Shares/ Share
Numerator Denominator Amount Numerator Denominator Amount
--------- ----------- ------ --------- ----------- ------
Net Income $2,354,000 $2,244,000
========== ==========
EPS -Income available
to common stockholders $2,354,000 4,173,776 $0.56 $2,244,000 3,965,496 $0.54
========== ==========
Effect of Dilutive
Securities - Stock Options 604,033 284,065
--------- ---------
EPS assuming dilution - Income
available to common
stockholders plus
assumed conversion $2,354,000 4,777,809 $0.49 $2,244,000 4,249,561 $0.50
========== ========= ===== ========== ========= =====
For the six months ended For the six months ended
June 30, 2002 June 30, 2001
------------------------------- ------------------------------
Per Per
Income/ Shares/ Share Income/ Shares/ Share
Numerator Denominator Amount Numerator Denominator Amount
---------- ----------- ------ --------- ----------- ------
Net Income $4,630,000 $4,323,000
========== ==========
EPS - Income available to
common stockholders $4,630,000 4,172,748 $1.11 $4,323,000 3,961,916 $1.04
========== ==========
Effect of Dilutive
Securities - Stock Options 558,765 324,480
--------- ---------
EPS assuming dilution -
Income available to
common stockholders
plus assumed conversion $4,630,000 4,731,513 $0.98 $4,323,000 4,286,396 $0.96
========== ========= ===== ========== ========= =====
Note 3 - Comprehensive Income
The Corporation's total comprehensive earnings presentation is as follows:
For the three For the six
months ended months ended
June 30, June 30,
(In thousands)
2002 2001 2002 2001
------ ------ ------ ------
Net Income $2,354 $2,244 $4,630 $4,323
------ ------ ------ ------
Other Comprehensive income (loss):
Change in unrealized holding gain
(losses) arising during the period 5 (4) 6 8
Income tax benefit (expense) (2) 2 2 (4)
3 (2) 4 4
------ ------ ------ ------
Comprehensive income $2,357 $2,242 $4,634 $4,327
====== ====== ====== ======
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Northern Empire Bancshares is the financial holding company of Sonoma National
Bank (the "Bank"). Since the principal business of the Corporation is the Bank,
the following discussion pertains mainly to the Bank.
This report contains "forward-looking statements" as defined in section 27A of
the Securities Act of 1933, as amended, and section 21E of the Securities
Exchange Act of 1934, as amended, which includes statements such as projections,
plans and objectives and assumptions about the future, and such forward looking
statements are subject to the safe harbor created by these sections. Many
factors could cause the actual results, amounts or events to differ materially
from those the Corporation expects to achieve or occur, such as changes in
competition, market interest rates, economic conditions and regulations.
Although the Corporation has based its plans and projections on certain
assumptions, there can be no assurances that its assumptions will be correct, or
that its plans and projections can be achieved.
Summary of Financial Results
Total consolidated assets equaled $646,215,000 at June 30, 2002 compared to
$561,004,000 at December 31, 2001. Net loans increased $62.2 million since
year-end with $43.7 million occurring in the second quarter. Cash and
equivalents increased $28.9 million during the second quarter.
Net income after tax for the first six months of 2002 equaled $4,630,000
compared to $4,323,000 for the comparable period last year, an increase of 7.1%.
The net income for the second quarter of $2,354,000 increased 4.9% over the
second quarter of 2001 when net income equaled $2,244,000. The higher profit
resulted from increases in net interest income due to loan growth.
Net Interest Income
Net interest income (before the provision for loan losses) of $6,415,000 for the
second quarter of 2002 increased 5.0% from $6,108,000 for the comparable period
last year.
Interest income decreased to $10,227,000 for the second quarter of 2002 compared
to $11,621,000 for the second quarter of 2001 due to the decline in yields on
earning assets which equaled 7.00% in the second quarter of 2002 compared to
9.25% for the same quarter of 2001. The impact of the declining rates was
mitigated by volume increases of $81.9 million in average earning assets when
comparing average earning assets for the second quarter of 2002 to the second
quarter of 2001. Average loans outstanding increased $59.5 million over the
second quarter of 2001 while average investments, certificates of deposits and
fed funds sold increased $22.4 million.
Interest expense decreased to $3,812,000 in the second quarter of 2002 from
$5,513,000 in 2001. The major factor was the decrease in the average cost of
funds to 3.23% for the second quarter of 2002 from 5.36% for the second quarter
of 2001. The benefit of the lower interest rate environment was offset by the
increase in average deposit and borrowings of $66.3 million when comparing the
second quarter of 2002 to 2001.
The average net interest margin equaled 4.39% during the second quarter of 2002
compared to an average margin for the second quarter of 2001 of 4.86% and 4.61%
for the year ended December 31, 2001. The yield on average loans equaled 7.65%
in the second quarter of 2002 compared to 9.70% for the same period last year,
while the Bank's cost of funds decreased to 3.13% for the second quarter of 2002
from 5.24% for the second quarter of 2001. The decline in yields on earning
assets and cost of funds resulted from decline in market rates due to general
economic conditions.
Several factors impact the Bank's interest margin. These include changes in
market interest rates, level of loans relative to deposits, mix of loans and
other earning assets, non-accrual loan balances and mix of deposits and other
funding sources.
* Changes in Market Interest Rates
Changes in economic condition and actions of Federal Reserve Board to reduce the
Fed Funds and Discount rates have a direct impact on the Bank=s net interest
margin since prime rate generally moves with Federal Reserve Board changes.
During 2001, The Federal Reserve Board lowered the Discount and Fed Funds rates
11 times to 40 year lows with prime rate also declining 11 times following the
Federal Reserve Board's actions. Prime rate declined to 4.75% on December 12,
2001and has remained at 4.75% through the second quarter of 2002. Prime was
9.50% at January 1, 2001 and declined to 8.00% at March 31, 2001 and 6.75% on
June 30, 2001. The rapid decline in prime rate had a negative impact on the
Bank's net interest margin and continues to have a negative impact as loan
products continue to reprice at lower rates depending upon their repricing
schedule and index. There are no assurances that earnings will not be adversely
impacted by future actions of the Federal Reserve Board and changes in market
interest rates.
The full impact of rate changes on the Bank's earnings is not realized for
several months, since not all loans or deposits reprice immediately. The Bank
has $126.6 million in SBA 7(a) loans which reprice based upon the prime rate on
the first day of the calendar quarter. The Bank has $189.0 million adjustable
rate loans, mainly commercial real estate loans, that are tied to the Eleventh
District Cost of Funds Index (COFI) which adjust at a slower pace. The COFI
index was 2.77% for May 2002 (latest available) and 3.07% for December 2001
compared to 5.62% for December 2000. The Bank also has a fixed rate loan
portfolio which generally reduces net interest margin as interest rates rise and
benefits interest margin as rates decline. The rate of loan prepayments has
increased as borrowers refinance to indexes which bear lower rates than loans
tied to COFI or fixed rates.
Of the Bank's loan portfolio totaling $536.3 million at June 30, 2002, $272.3
million or 50.8% of total loans are adjustable rate loans which have not reached
a floor or ceiling rate. Approximately $158.9 million are prime-based loans, of
which $32.1 million reprice immediately and $126.8 million reprice on a
quarterly basis.
Market rates also impact the Bank's ability to attract deposits and grow the
loan portfolio. The current low rates offered on deposits makes them less
attractive to depositors.
Interest rates offered on deposits have been relatively stable during the first
and second quarters of 2002 and remain at historically low levels. The Bank had
$125.0 million in Sonoma Investor Reserve accounts (money market rate deposit
accounts). The cost of these deposits equaled 1.82% during the second quarter
of 2002 compared to 3.49% for the second quarter last year.
The Bank has $330.7 million in time certificates of deposits. These accounts
reprice at a slower pace similar to the Prime Rate loans discussed above. The
cost of time deposits equaled 3.98% for the second quarter of 2002 compared to
6.35% in the second quarter of the preceding year. The benefit of lower rates
on time deposits will continue to occur as certificates of deposits mature and
are renewed at the lower rates offered on their maturity dates. The Bank has
offered competitive market rates for deposits when compared to financial
institutions in our area.
* Level of Loans Relative to Deposits
The Bank's ratio of loans to deposits averaged 100.2% in the second quarter of
2002 compared to 97.5% for the same period last year. A higher loan to deposit
ratio has a beneficial impact on the Bank's net interest margin, since loans
generally have a higher yield than other types of earning assets. The Bank has
been able to increase the level of loans relative to deposits as a result of the
large line of credit with the Federal Home Loan Bank (FHLB). FHLB provides a
lower cost source of funds than deposits. The average cost of FHLB advances
equaled 2.47% during the second quarter compared to the cost of time deposits
which equaled 3.98% during the same period.
* Mix of Loan and Earning Assets
The mix of loans influences the overall yield on loans. The largest loan growth
occurred in real estate loans, which grew $62.7 million since December 31, 2001
to $347.5 million at this quarter end. Commercial loans grew $11.0 million
since December 31, 2001 (SBA loans, which generally are secured by real estate,
are classified as commercial loans). This category has a higher yield than other
types of loans. Construction loans decreased from $49.6 million at year-end to
$38.7 million at the end of this quarter. Construction loans have higher yields
than other real estate loans; however, they have been declining due to general
economic conditions.
* Non-Accrual Loan Balances
Loans which have been placed on non-accrual status also impact the net interest
margin. At the time a loan is placed on non-accrual, the unpaid interest is
reversed and interest accruals are discontinued until the credit quality of the
loan justifies returning it to accrual status. As of December 31, 2001 the Bank
had $2,156,000 in non-accrual loans compared to $1,918,000 million at the end of
this quarter. When a non-accrual loan pays off or is reinstated to accrual
status the interest income is reinstated to income which has a positive effect
on loan yields. At June 30, 2002 non-accrual loans equaled 0.36% of total
loans. The current level of non-accrual loans is considered by management to be
a low level of non-accrual loans based upon comparisons to our peer group (other
banks of comparable asset size). See Allowance for Loan Losses for additional
information.
* Mix of Deposits and Other Funding Sources
The mix of funding sources determines the cost of funds for the Bank.
Certificates of deposit reprice at the time the certificate matures which delays
the benefit to the Bank's cost of funds in a downward interest market. Sonoma
Investor Reserve accounts can be repriced weekly; and therefore, the benefit of
falling interest rates is more immediate. Competition also is a factor in the
repricing of certain deposit products. While prime rate drops immediately on
loans it often takes longer to receive the same benefit when repricing market
rate deposits due to competitive rates in our market area. The Bank also has a
borrowing line with the Federal Home Loan Bank which has been used as a source
of liquidity. The borrowing rates are often below rates offered on certificates
of deposits and the Bank will be increasing the use of this line as a way to
reduce our cost of funds.
The following is an analysis of the net interest margin:
Three months ended Three months ended
June 30, 2002 June 30, 2001
(dollars in thousands)
Average Average
Balance Interest Yield Balance Interest Yield
------- -------- ----- ------- -------- -----
Earning assets (1) $585,962 $10,227 7.00% $504,058 $11,621 9.25%
Interest bearing
liabilities 421,622 3,812 3.13% 421,623 5,513 5.24%
------- -------
Net interest income $6,415 $6,108
======= =======
Net Interest income
to earning assets 4.39% 4.86%
==== ====
(1) Non-accrual loans are included in the calculation of average balance of
earning assets, and interest not accrued is excluded.
Six months ended Six months ended
June 30, 2002 June 30, 2001
(dollars in thousands)
Average Average
Balance Interest Yield Balance Interest Yield
------- -------- ----- ------- -------- -----
Earning assets (1) $560,898 $19,910 7.16% $495,431 $22,953 9.34%
Interest bearing
liabilities 467,222 7,483 3.23% 415,035 11,024 5.36%
------- -------
Net interest income $12,427 $11,929
======= =======
Net Interest income
to earning assets 4.47% 4.86%
==== ====
(1) Non-accrual loans are included in the calculation of average balance of
earning assets, and interest not accrued is excluded.
The following table sets forth changes in interest income and interest expense
for each major category of interest-earning asset and interest-bearing
liability, and the amount of change attributable to volume and rate changes for
the three and six months ended June 30, 2002 and 2001. Changes not solely
attributable to rate or volume have been allocated to rate.
For the three months ended June 30, 2002
over June 30, 2001
(dollars in thousands)
Yield/
Volume Rate Total
------ ------ ------
Increase (decrease) in interest income:
Portfolio loans $5,599 ($6,814) ($1,215)
Other earning assets 955 (1,134) (179)
------ ------ ------
Total increase (decrease) 6,554 (7,948) (1,394)
------ ------ ------
Increase in interest expense
Interest-bearing transaction accounts 329 (830) (501)
Time deposits 1,574 (2,946) (1,372)
Other borrowings 1,665 (1,493) 172
------ ------ ------
Total increase 3,568 (5,269) (1,701)
------ ------ ------
Increase (decrease) in net interest income $2,986 ($2,679) $307
====== ====== ======
For the six months ended June 30, 2002
over June 30, 2001
(dollars in thousands)
Yield/
Volume Rate Total
------ ------ ------
Increase (decrease) in interest income:
Portfolio loans $4,234 ($6,814) ($2,580)
Other earning assets 1,031 (1,494) (463)
------ ------ ------
Total increase (decrease) 5,265 (8,308) (3,043)
------ ------ ------
Increase in interest expense
Interest-bearing transaction accounts 468 (1,634) (1,166)
Time deposits 1,107 (3,727) (2,620)
Other borrowings 1,149 (904) 245
Total increase 2,724 (6,265) (3,541)
------ ------ ------
Increase (decrease) in net interest income $2,541 ($2,043) $498
====== ====== ======
Provision for Loan Losses
The provision for loan losses equaled $150,000 for the three months ended June
30, 2002 and $300,000 for the first six months of 2002 compared to $240,000 and
$480,000 for the same periods in 2001. The provision is intended to maintain
the Allowance for Loan Losses given the overall growth in loans and the level of
non-accrual loans. For further discussion see Allowance for Loan Losses
Other Income
Other income is derived primarily from service charges, SBA loan sales, SBA loan
servicing and sales of other real estate owned. Other income increased to
$532,000 from $460,000 when comparing the second quarter of 2002 to the same
period last year.
* Service Charges
Service charges on deposit accounts equaled $120,000 in the second quarter of
2002 compared to $101,000 for the same period last year. The increase relates
to charges on analysis customers. The earnings credit rate has remained at a
low level due to the declining interest rate environment. Analysis customers
earn less on their average balance to cover the cost of services provided to
them. If the earnings credit do not cover the cost of services they are charged
a service fee. The Bank also receives fees for safe deposit, visa, and other
services.
* SBA Loan Sales and Loan Participations
In the second quarter of this year, the Bank sold the guaranteed portion of SBA
loans totaling $3.7 million and participated $9.9 million in commercial real
estate loans. The sale of SBA loans resulted in $251,000 in gains on sale of
SBA loans. During the second quarter of last year, the Bank sold the guaranteed
portion of SBA loans totaling $2.4 million and recognized gains on those sales
of $164,000. The Bank continues to retain the majority of the SBA loans it
makes, in order to realize the interest yield, rather than selling the
guaranteed portion for a one time gain and servicing fees. Management considers
the Bank's liquidity needs and anticipates loan and deposit growth as a part of
the decision to hold SBA guaranteed loans versus selling them. The premiums on
loan sales remained at higher levels over those received in earlier quarters of
last year. The average premium on sales in the second quarter of 2002 equaled
6.8%. Premiums are market driven based upon factors such as rate of prepayment
of SBA loans experienced throughout the country. There is no guarantee that
premiums will continue at the current level.
During the second quarter, the Bank participated $9.9 million in commercial real
estate loans to other California financial institutions. These participations
are treated as loan sales and due to the terms of the participations the Bank
recognized a loss of $5,000 on these sales. Management considers the Bank's
liquidity needs and anticipates loan and deposit growth as a part of the
decision to participate loans. During the second quarter of 2002, loan growth
was strong and the funds from these transactions were used to fund new loan
growth.
* SBA Loan Servicing
SBA servicing fees totaled $66,000 during the second quarter of 2002, compared
to fees of $78,000 recorded in the second quarter of last year. The income
varies depending on the fee income calculated based upon the payments received
during the period and the size of the portfolio serviced. The serviced portfolio
equaled $35.2 million at June 30, 2002 compared to $31.7 million at June 30,
2001.
* Sales of Other Real Estate Owned
There were no sales of other real estate owned (OREO) during the second quarter
of 2002 or 2001.
Non-Interest Expenses
The Bank's non-interest expenses increased to $2,824,000 for the second quarter
of this year compared to $2,535,000 from the second quarter of 2001. This
increase was anticipated since the Bank has continued to grow at a rapid rate.
* Salaries and Employee Benefits
The Bank's largest expense category is salaries and benefits which increased
14.4% to $1,699,000 up from $1,485,000 for the second quarter of 2001 The Bank's
full time equivalent (FTE) staff level has increased to 114 in June 2002 from
108 in June 30, 2001. The Bank hired an Executive Vice President in charge of
Corporate Development, a new branch manager for the Main Branch and several new
loan support employees to manage the high loan volume. Incentive payments
continue at a high level due to growth in the loan portfolio. Personnel costs
are also affected by annual salary increases and changes in benefit costs and
are expected to continue to increase as the Bank grows.
* Occupancy and Equipment
Occupancy expenses increased 16.7%, mainly due to rent increases on existing
facilities and special billings for cost increases on maintaining the properties
as called for in the lease agreements. The Bank is currently working on tenant
improvements for a new branch located in the city of Sonoma, California which is
projected to open this fall. In August 2001, the Bank relocated its computer
operations to a separate location, which has increased our occupancy costs
relative to the second quarter of 2001. Equipment costs increased to $153,000 up
from $148,000 for the second quarter last year. The Bank continues to upgrade
computer equipment and operations. It is expected that equipment costs will
continue to increase.
* Deposit and Other Insurance
Deposit and other insurance of $80,000 increased from $74,000 for the same
period of last year. The increase results from growth of the Bank, which
determines the regulatory assessments. There is no assurance that regulatory
assessments will continue at the current low level. The cost of other insurance
is included in this category.
* Professional Services
Professional fees increased to $75,000 for the second quarter of 2002 up from
$28,000 for the same period last year. Legal expenses vary depending upon
problem loans requiring outside counsel (See discussion on Allowance for Loan
Losses) and other professional services vary depending upon the scheduling of
other contracted services such as loan reviews, tax services, and other
consulting services. The Bank has increased the use of consultants to assist in
special projects such as interest rate risk and deposit decay analyses. It is
expected that this trend will continue.
* Business Development and Advertising
Advertising and business development costs, which vary depending on the timing
of loan and deposit promotions, was relatively unchanged at $125,000 for the
quarter compared to $122,000 in the second quarter of 2001.
* Outside Customer Services
Outside customer services declined17.0% to $88,000. This decline resulted from
a change in the analysis activity of one large analysis account. The Bank pays
for certain direct costs (i.e.: payroll services, escrow fees, etc.) which are
expensed. The analysis customer receives earnings credits based upon their
deposit account balances which can be used to offset these charges. The customer
is charged a bank service fee if their earnings credits do not cover the costs.
* Shareholder and Director Expenses
Second quarter expenses for shareholder and director expenses equaled $98,000,
up from $69,000 for the second quarter of last year. Included in this category
are directors' fees for attending Board, Loan Committee, Asset Liability
Committee (ALCO), Executive Committee, Audit Committee and Personnel Committee
meetings. The increase results from increased frequency of ALCO meetings and
larger Executive Committee meetings. In addition, the fee for ALCO meetings was
increased to $500 per meeting in recognition of the expanded responsibilities of
ALCO members. The cost of the Corporation's annual report, transfer agent fees
and other costs of communicating with shareholders is included in this expense
category.
* Other Expenses
Other expenses, which includes stationery and supplies, telephone, postage, loan
expenses, dues and subscriptions and automobile costs have decreased due to cost
controls to $241 in the second quarter of 2002 compared to $276 for the same
period in 2001.
Total non-interest expenses for the SBA lending department for the second
quarter of 2002 was approximately $532,000 ($376,000 in personnel costs, $60,000
in occupancy and equipment expenses, $28,000 in marketing/business development
and $68,000 in other expenses) compared to $442,000 for the second quarter of
2001. The SBA department's loan portfolio includes $161.7 million of SBA 7(a)
loans and $155.6 of commercial real estate and other loans of which $35.2
million has been sold and is being serviced.
Income Taxes
The effective tax rate was 40.8% for the second quarter of 2002 unchanged from
the comparable quarter last year. The provision for the second quarter of 2002
was $1,619,000 versus $1,549,000 for the same period last year. The increase
resulted from the increase in pre-tax income during the comparable quarters.
Liquidity and Investment Portfolio
Liquidity is a bank's ability to meet possible deposit withdrawals, to meet loan
commitments and increased loan demand, and to take advantage of other investment
opportunities as they arise. The Bank's liquidity practices are defined in both
the Asset and Liability Policy and the Investment Policy. These policies define
acceptable liquidity measures in terms of ratios to total assets, deposits,
liabilities and capital.
Cash and due from banks and federal funds sold totaled $104.1 million or 16.1%
of total assets at June 30, 2002, compared to $82.2 million or 14.7% of total
assets at December 31, 2001. The Bank sold $3.7 million in SBA loans and
participated $9.9 million in commercial real estate loans during the second
quarter of 2002 to increase the Bank's liquidity. As of June 30, 2002 the Bank
held $83.7 million in SBA guaranteed loans which could be sold if additional
liquidity was needed.
At June 30, 2002, the Bank had unused federal funds lines of credit totaling $11
million. The Bank also has a credit line with the Federal Home Loan Bank (FHLB)
which is based upon the value of collateral (investments and loans). The Bank
has collateral pledged which would allow the Bank to borrow up to $100.8
million. As of June 30, 2002, the Bank had borrowed $36.8 million leaving $64.0
million available for future liquidity needs. The Bank could borrow an amount
equal to 25% of our assets, assuming that collateral values would support that
level of borrowings. Management believes this amount of secondary liquidity is
adequate to meet any cash demands that may arise.
At present, the Corporation's primary sources of liquidity are from interest on
deposits, exercise of stock options and dividends from the Bank. The Bank's
ability to pay dividends to the Corporation is subject to the restrictions of
the national banking laws and, under certain circumstances, the approval of the
Comptroller of the Currency.
At June 30, 2002, the Corporation had non-interest and interest bearing cash
balances of $301,000, which management believes is adequate to meet the
Corporation's operational expenses.
The Corporation and the Bank do not engage in hedging transactions (interest
rate futures, caps, swap agreements, etc.).
Deposits
During the second quarter of 2002 total deposits increased by $56.4 million to
$557.0 million at June 30, 2002.
Money market deposits totaling $125.0 million at June 30, 2002 had declined from
$137.8 at December 31, 2001. This is a limited transaction account with a
discretionary rate which is set by management. The rate offered on this account
dropped significantly during the first quarter of this year as a result of the
declining rate environment. The lower rates offered have negatively impacted
the growth of this account. There has also been increased competition in our
market area for these types of funds with local financial institutions offering
high rates on money market accounts. The Bank's customers have held their funds
in this deposit product rather than locking into a specific maturity since the
certificate of deposit rates, especially for short term maturities, have been
comparable.
Certificates of deposits increased to $330.7 million from $278.8 million as of
June 30, 2001. The Bank attracted $18 million in time deposits from other
financial institutions through an Internet listing service at rates below rates
offered in the Bank's market area. The Bank has increased certificates of
deposit by offering attractive rates on certificates for specific terms. The
Bank has been successful in retaining the majority of funds received through
certificate advertising campaigns; however, with the lower rate environment
deposits have become more volatile. Depositors are negotiating rates based upon
specials offered in the local market, and there is increased competition for
these deposits.
As of June 30, 2002, non-interest bearing deposits equaled $73.9 million
compared to $59.4 million at December 31, 2001. The Bank's transaction accounts
have significant changes in daily balances, mainly due to deposits held by title
companies. This type of deposit account has greater balance fluctuations than
other types of accounts based upon their business activity.
The low interest rate environment over the last six months and the increased
competition from the financial services industry has made it more difficult to
attract new deposits at favorable rates. The Bank continually monitors
competitors' rates, strives to be competitive in pricing deposits, and has
offered attractive time deposit rates to raise funds during periods of high loan
growth.
Loans
Loans, net of discounts and reserves, equaled $528.8 million at June 30, 2002
compared to $466.5 million at December 31, 2001, increasing 13.4% over year-end
and 14.9% over the June 30, 2001 balance of $460.1 million.
The following is an analysis of the loan portfolio.
Type of Loan June 30, December 31,
(in thousands) 2002 2001
Commercial $148,748 $137,711
Real Estate Construction 38,691 49,604
Real Estate Other 347,462 284,782
Installment Loans to Individuals 1,431 2,052
536,332 474,149
Deferred loan fees and discount (1,672) (2,004)
Allowance for loan losses (5,889) (5,616)
-------- --------
TOTAL $528,771 $466,529
======== ========
The SBA loan program continued to be a popular program and competition continues
to be strong in our market area. At June 30, 2002, loans with SBA guarantees
equaled $126.5 million, net of $35.2 million in SBA loans sold and being
serviced by the Bank. The majority of the Bank's SBA loans are secured by real
estate; however, these loans are reported as commercial loans. SBA loans have
the same underwriting requirements, as the Bank's other loans. They are
sometimes for longer terms (7 to 25 years) and have higher loan-to-value ratios
than the Bank typically accepts. The SBA loan program remains subject to budget
considerations at the Federal government level. Major changes to the federal
program could affect the Bank's profitability and future SBA loan growth. The
guaranteed portion of SBA loans currently held by the Bank which could be sold
in the secondary market increased to $83.7 million at June 30, 2002 from $65.5
million at June 30, 2001.
The Bank continues to emphasize commercial and real estate lending. At June 30,
2002, 27.7% of the loans held for investment were commercial loans and 72.0%
were real estate and construction loans, compared to 29.0% and 70.5%
respectively at December 31, 2001. The Bank has increased the commercial and
commercial real estate portfolio through its reputation in Sonoma and
surrounding counties as an experienced business and real estate lender that
facilitates the successful negotiation of complex commercial loans. The Bank
maintains high credit qualifications with most real estate loans having 60-70%
loan-to-value ratios. Management is aware of the risk factors in making
commercial and real estate loans and is continually monitoring the local market
place. A decline in real estate values and/or demand could potentially have an
adverse impact on the loan portfolio, and on the financial condition of the
Bank.
Construction loans equaled $38.7 million from $49.6 million at December 31,
2001. The Bank has continued to be committed to residential construction
lending; however, the economic conditions have resulted in a softening of the
demand for construction loans. Construction loans are made to owner/occupied
and owner/users of the properties and occasionally to developers with a
successful history of developing projects in the Bank's market area. The
construction lending business is subject, to among other things, the volatility
of interest rates, real estate prices in the area and the market availability of
conventional real estate financing to repay such construction loans. A decline
in real estate values and/or demand could potentially have an adverse impact on
this portion of the loan portfolio and on the earnings and financial condition
of the Bank.
The Bank offers residential mortgages on a limited basis. The Bank has a small
portfolio of consumer loans which equaled 0.3% of the total loan portfolio at
June 30, 2002.
Allowance for Loan Losses
The allowance for loan losses equaled $5,889,000 at June 30, 2002, compared to
$5,616,000 at December 31, 2001. At June 30, 2002 the allowance for loan losses
equaled 1.3% of loans, net of the guaranteed portion of SBA loans. The
allowance for loan losses is reviewed on a monthly basis, based upon an
allocation for each loan category, plus an allocation for any outstanding loans
which have been classified by regulators or internally for the "Watch List".
Each loan that has been classified is individually analyzed for the risk
involved with a specific reserve allocation assigned according to the risk
assessment.
At June 30, 2002, there were five borrowers on non-accrual totaling $1,918,000
of which $1,562,000 was collateralized by real estate and the SBA guaranteed
$1,162,000. There was one loan for $894,000 that was secured by real estate
which was past due 90 days or more and still accruing interest. Loans past due
30 to 89 days totaled $7,870,000 of which $7,841,000 was collateralized by real
estate and $1,315,000 was guaranteed by the SBA. On December 31, 2001, the Bank
had $2,156,000 in non-accrual loans, and no loans past due 90 or more days and
still accruing interest.
During the second quarter of 2002 there were $8,000 in loan charge offs and
$27,000 in loan charge offs for the year-to-date. During the first six months
of 2001 there was $24,000 in charge offs and no recoveries. The Bank has a low
charge off experience compared to industry standards, but there is no guarantee
that this will continue. The following is an analysis of the activity in the
allowance for loan losses during the quarter and year-to-date.
(In thousands) Quarter ended Six months ended
June 30, 2002 June 30, 2001
Balance - Beginning of period $5,747 $5,616
Provision for loan losses 150 300
Charge offs (8) (27)
Recoveries - -
------ ------
Balance - End of period $5,889 $5,889
====== ======
Capital Resources
Pursuant to regulations under the FDIC Improvement Act of 1991 (FDICIA), five
capital levels were prescribed as applicable for banks, ranging from
well-capitalized to critically under-capitalized. At June 30, 2002, the Bank
was considered "well capitalized." The total risk-based capital ratios were
11.5% for the Bank and 11.5% for the Corporation.
A March 26, 2002, the Corporation declared a 5% stock dividend to shareholders
of record on April 30, 2001.
ITEM 3. Quantitative and Qualitative Disclosures about Market Risk
The Bank's financial performance is impacted by, among other factors, interest
rate risk and credit risk. The Bank utilizes no derivatives to mitigate its
credit risk, relying instead on loan review and adequate loan loss reserves.
See Allowance for Loan Losses.
Interest rate risk is the risk of loss in value due to changes in interest
rates. Since virtually all of the Corporation's interest rate risk exposure
lies at the Bank level, this risk is addressed by the Bank's Asset Liability
Committee ("ALCO"), which includes members of the Board of Directors and senior
officers of the Bank. ALCO attempts to manage the various components of the
Corporation's balance sheet to minimize the impact of sudden and sustained
changes in interest rates on portfolio values and net interest income.
A fundamental objective is to manage its assets and liabilities to maximize the
economic value of the Bank while maintaining adequate liquidity and minimizing
exposure to interest rate risk. Management believes an acceptable degree of
exposure to interest rate risk results from the management of assets and
liabilities through maturity, pricing and mix with the goal of limiting its
exposure to interest rate risk. The Bank's profitability is dependent to a
large extent upon its net interest income. The Bank is subject to interest rate
risk to the degree that its interest-earning assets reprice differently than its
interest-bearing liabilities.
Interest rate sensitivity analysis is used to measure the Bank's interest rate
risk by computing estimated changes in the net present value (NPV) of its cash
flows from assets, liabilities and off-balance sheet items in the event of a
range of assumed changes in market interest rates. NPV represents the market
value of portfolio equity and is equal to the market value of assets minus the
market value of liabilities, with adjustments made for off-balance sheet items.
This analysis assesses the risk of loss in market rate sensitive instruments in
the event of sudden and sustained increases and decreases in market interest
rates. The Bank has no trading securities.
Management expects that, in a declining rate environment, the Bank's net
interest margin would tend to decline, and, in an increasing rate environment,
the Bank=s net interest margin would tend to increase. On a monthly basis,
management prepares an analysis of interest rate risk exposure. Such analysis
calculates the change in net interest income given a change in general interest
rates of 200 basis points up or down. All changes are measured in dollars and
are compared to projected net interest income and the value of the Bank=s equity
is calculated by discounting cash flows associated with the Bank's assets and
liabilities. The following table summarizes the simulated change in net
interest income based on the twelve months ending December 31, 2002, given a
change in general interest rates of 200 basis points up or down.
Change in Estimated Estimated Change in
Interest Rate Net Interest Income Net Interest Income
+200 $25,599 $1,850
+100 24,535 786
Base Scenario 23,749 -
-100 22,857 (891)
-200 22,222 (1,527)
The model utilized by management to create the report presented above makes
numerous assumptions, including relative levels of market interest rates, loan
prepayments and deposit runoff and should not be relied upon as indicative of
actual future results. Computations do not contemplate any actions that ALCO
could undertake in response to changes in interest rates. Actual results could
differ significantly from those estimates, which would result in significant
differences in the calculated projected change.
Interest rate risk management is a function of the repricing characteristics of
the portfolio of assets and liabilities. Interest rate risk management focuses
on the maturity structure of assets and liabilities and their repricing
characteristics during periods of changes in market interest rates. Effective
interest rate risk management seeks to ensure that both assets and liabilities
respond to changes in interest rates within an acceptable time frame, thereby
minimizing the effect of interest rate movements on net interest income.
Interest rate sensitivity is measured as the difference between the volume of
assets and liabilities in the current portfolio that is subject to repricing at
various time horizons. The differences are known as interest rate sensitivity
gaps.
The following schedule represents interest rate sensitivity profile as of June
30, 2002 of assets, liabilities and shareholders' equity classified by earliest
possible repricing opportunity or maturity date.
Over 3 Over 1 Non-rate
Balance Sheet months year Sensitive
(in thousands) Through3 through through or Over
3 months 1 year 5 years 5 years Total
-------- ------- -------- ------- ------
Assets
Fed funds sold &
certificates of deposit $83,922 $83,922
Investment securities $646 $2,004 $ 2,650
Loans (net of discounts) 222,577 103,726 $145,032 63,325 534,660
Non-interest-earning
assets (net of allowance
for loan losses) 24,983 24,983
-------- -------- -------- ------- --------
$306,499 $103,726 $145,678 $90,312 $646,215
======== ======== ======== ======= ========
Liabilities &
Shareholders' Equity
Time Deposits
$100,000 and over $26,396 $85,221 $26,818 $138,435
All other interest
bearing liabilities 220,046 117,461 42,174 $1,790 381,471
Non-interest bearing
liabilities 63,159 63,159
Other Liabilities &
Shareholders' Equity 43,600 43,600
-------- -------- -------- ------- --------
$246,442 $202,682 $68,992 $128,099 $646,215
-------- -------- -------- ------- --------
Interest Rate
Sensitivity (1) $60,057 ($98,956) $76,686 $(37,787)
-------- -------- -------- -------
Cumulative Interest
Rate Sensitivity $60,057 ($38,899) $37,787 -
-------- -------- -------- -------
(1) Interest rate sensitivity is the difference between interest rate sensitive
assets and interest rate sensitive liabilities within the above time frames.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings -
None other than in the ordinary course of business.
Item 2. Changes in Securities and Use of Proceeds - None
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Shareholders of the Corporation was held
on May 21, 2002. The following candidates received the votes
indicated.
Withheld/Abstained/
For Broker Non-Votes
Clement C. Carinalli 3,525,605 375
Patrick R. Gallaher 3,525,605 375
William P. Gallaher 3,525,269 711
William E. Geary 3,525,605 375
James B. Keegan, Jr. 3,525,605 375
Dennis R. Hunter 3,525,605 375
Robert V. Pauley 3,521,378 4,602
All candidates were re-elected.
No other matters were voted on at the meeting.
Item 5. Other Information -None
Item 6. Exhibits and Reports on Form 8-K
a. Exhibits:
(3) (a) Articles of Incorporation of the Corporation (filed as
Exhibit 3.1 to the Corporation's S-1 Registration Statement,
filed May 18, 1984 and incorporated herein by this reference).
(b) Certificate of Amendment to Articles of Incorporation, filed
January 17, 1989 (filed as exhibit (3)(b) to the Corporation's
Annual Report on Form 10-K for the Fiscal Year Ended December 31,
1988 and incorporated herein by this reference).
(c) Bylaws of the Corporation, as amended (filed as Exhibit 3.2
to the Corporation's S-2 Registration Statement, File No. 33-51906
filed September 11, 1992 and incorporated herein by this reference).
(d) Amendment to the Bylaws of the Corporation and revised Bylaws
(filed as Exhibit (3)(d) to the Corporation's Annual Report on
Form 10-KSB for the Fiscal Year Ended December 31, 1994 and
incorporated herein by this reference).
(e) Secretary's certificate of Amendment to the Bylaws of the
Corporation and revised Bylaws ((filed as Exhibit (3)(e) to the
Corporation's Annual Report on Form 10-KSB for the Fiscal Year
Ended December 31, 1997 and incorporated herein by this reference).
b. Reports on Form 8-K - None
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
NORTHERN EMPIRE BANCSHARES
Date: August 8, 2002
/s/Dennis R. Hunter /s/ Partick R. Gallaher
- ------------------- -----------------------
Dennis R. Hunter Patrick R. Gallaher
Chairman of the Board Chief Accounting Officer