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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 September 30, 2004
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 (I.R.S. Employer
incorporation 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 ____
Indicate by check mark whether the registrant is an accelerated filer (as
defined in rule 12b-2 of the Exchange act). 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
October 15, 2004: 9,882,567
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NORTHERN EMPIRE BANCSHARES AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(Unaudited)
(dollars in thousands)
ASSETS September 30, 2004 December 31, 2003
------------------ -----------------
Cash and equivalents:
Cash and due from banks $ 25,744 $ 20,078
Federal funds sold 106,683 74,496
---------- ---------
Total cash and equivalents 132,427 94,574
Investment securities
available-for-sale 1,089 632
Federal Home Loan Bank (FHLB)
stock, at cost 7,894 5,961
Federal Reserve Bank stock, at cost 192 165
Loans receivable, net of discounts
and allowance for loan losses 870,084 733,857
Leasehold improvements and
equipment, net 2,756 1,586
Accrued interest receivable
and other assets 13,662 11,451
---------- ---------
Total assets $1,028,104 $848,226
========== =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Liabilities:
Deposits $ 777,875 $658,320
Accrued interest payable and
other liabilities 5,652 3,162
FHLB Advances 161,921 119,211
---------- ---------
Total liabilities 945,448 780,693
Shareholders' equity:
Common stock, no par value;
authorized, 40,000,000 shares;
shares issued and outstanding,
9,882,567 at September 30, 2004
and 9,491,422 at December 31, 2003
(retroactively stated for 5% stock
dividend) 47,461 34,653
Additional paid-in-capital 3,775 1,702
Accumulated other comprehensive
(loss)/income (6) 2
Retained earnings 31,426 31,176
---------- ---------
Total shareholders' equity 82,656 67,533
Total liabilities and
shareholders' equity $1,028,104 $848,226
========== =========
See Notes to Consolidated Financial Statements
NORTHERN EMPIRE BANCSHARES AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF INCOME
for the three and nine months ended
September 30, 2004 and 2003
(Unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
(dollars in thousands,
except per share data)
2004 2003 2004 2003
------ ------ ------- -------
Interest income:
Loans $13,480 $11,096 $38,391 $32,299
Federal funds sold and
investment securities 424 296 971 770
------ ------ ------- -------
Total interest income 13,904 11,392 39,362 33,069
Interest expense 3,924 3,423 10,731 10,612
------ ------ ------- -------
Net interest income before
provision for loan losses 9,980 7,969 28,631 22,457
Provision for loan losses 475 150 1,025 750
------ ------ ------- -------
Net interest income after
provision for loan losses 9,505 7,819 27,606 21,707
------ ------ ------- -------
Other income:
Service charges on deposits 96 138 348 447
Gain on sale of loans 594 352 1,294 1,052
Other 275 268 905 678
------ ------ ------- -------
Total other income 965 758 2,547 2,177
------ ------ ------- -------
Other expenses:
Salaries and employee benefits 2,711 2,289 7,486 6,350
Occupancy 364 312 1,008 921
Equipment 266 208 682 562
Advertising and business
development 168 155 471 427
Outside customer services 100 89 273 255
Director and shareholder expenses 127 100 290 308
Deposit and other insurance 121 93 345 276
Professional fees 161 62 354 279
Other 338 304 938 904
------ ------ ------- -------
Total other expenses 4,356 3,612 11,847 10,282
------ ------ ------- -------
Income before provision
for income taxes 6,114 4,965 18,306 13,602
Provision for income taxes 2,503 1,945 7,465 5,391
------ ------ ------- -------
Net income $3,611 $3,020 $10,841 $ 8,211
====== ====== ======= =======
Basic earnings per common share $ 0.37 $ 0.33 $ 1.11 $ 0.89
====== ====== ======= =======
Diluted earnings per common share $ 0.32 $ 0.29 $ 0.97 $ 0.78
====== ====== ======= =======
See notes to Consolidated Financial Statements
NORTHERN EMPIRE BANCSHARES AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
Nine months ended
September 30,
(dollars in thousands) 2004 2003
-------- --------
Cash flows from operating activities:
Net income $ 10,841 $ 8,211
Adjustments to reconcile net income to net
cash provided by operating activities:
Provision for loan losses 1,025 750
Depreciation and amortization 448 385
FHLB Stock dividends (191) (118)
Tax benefit from stock option exercised 2,073 -
Gain on sale of loans (1,294) (1,052)
Change in deferred income taxes (573) (104)
Change in operating assets and liabilities:
Change in deferred loan fees and discounts 134 (494)
Change in interest receivable and other assets (1,637) (363)
Change in accrued interest payable and
other liabilities 2,490 669
-------- --------
Net cash provided by operating activities 13,316 7,884
-------- --------
Cash flows from investing activities:
Purchases of investment securities (1,096) -
Proceeds from the sale of investment securities 631 10
Purchase of restricted stock (1,770) (1,145)
Net decrease in interest bearing deposits - 198
Net increase in loans receivable (136,092) (80,863)
Purchase of leasehold improvements and
equipment, net (1,618) (587)
-------- --------
Net cash used by investing activities (139,945) (82,387)
-------- --------
Cash flows from financing activities:
Net increase in deposits 119,555 54,192
Net increase in FHLB advances 42,709 24,443
Cash paid for fractional shares (6) (7)
Stock options exercised 2,223 116
-------- --------
Net cash provided by financing activities 164,481 78,744
-------- --------
Net change in cash and cash equivalents 37,852 4,241
Cash and cash equivalents, at beginning of year 94,575 87,463
-------- --------
Cash and cash equivalents, at end of period $132,427 $ 91,704
======== ========
Supplemental cash-flows information from:
Interest paid $ 10,370 $ 10,737
Income taxes paid 4,231 5,402
See Notes to Consolidated Financial Statements
Northern Empire Bancshares and Subsidiary
Notes to Consolidated Financial Statements
September 30, 2004
Note 1 - Basis of Presentation
The unaudited financial information contained in this report reflects all
adjustments which, in the opinion of Management, are necessary to present
fairly the financial condition of Northern Empire Bancshares and Subsidiary
at September 30, 2004 and the results of operations for the three and nine
months then ended. The results of operations for the nine months ended
September 30, 2004 are not necessarily indicative of the operating results
to be anticipated for the year ended December 31, 2004.
The preparation of the consolidated financial statements in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect amounts reported
in the consolidated financial statements. Changes in these estimates and
assumptions are considered reasonably possible and may have a material
impact on the consolidated financial statements and thus actual results
could differ from the amounts reported and disclosed herein. The Company
considers the allowance for loan loss a critical accounting policy subject
to estimate.
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 2003 Annual Report on Form 10-K.
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 income
available to 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 adjusted for the impact of the 5% stock dividend declared on
March 16, 2004 and the two for one stock split to shareholders of record on
December 1, 2003. The Corporation's pertinent EPS data is as follows:
For the three months ended For the three months ended
September 30, 2004 September 30, 2003
Income/ Shares/ Per Share Income/ Shares/ Per Share
Numerator Denominator Amount Numerator Denominator Amount
---------- ----------- --------- ---------- ----------- ---------
Net Income $3,611,000 $3,020,000
========== ==========
EPS -Income available
to common stockholders $3,611,000 9,880,219 $0.37 $3,020,000 9,229,765 $0.33
========= ==========
Effect of dilutive
Securities-Stock Options 1,409,845 1,256,809
---------- ----------
EPS assuming dilution-
Income available to common
stockholders plus
assumed conversion $3,611,000 11,290,064 $0.32 $3,020,000 10,486,574 $0.29
========== ========== ===== ========== ========== =====
For the nine months ended For the nine months ended
September 30, 2004 September 30, 2003
Income/ Shares/ Per Share Income/ Shares/ Per Share
Numerator Denominator Amount Numerator Denominator Amount
---------- ----------- --------- ---------- ----------- ---------
Net Income $10,841,000 $8,211,000
========== ==========
EPS-Income available
to common stockholders $10,841,000 9,746,190 $1.11 $8,211,000 9,229,221 $0.89
========== ==========
Effect of dilutive
Securities-Stock Options 1,397,232 1,284,148
---------- ----------
EPS assuming dilution-
Income available to common
stockholders plus
assumed conversion $10,841,000 11,143,422 $0.97 $8,211,000 10,513,369 $0.78
========== ========== ===== ========== ========== =====
Note 3 - Stock Based Compensation
The Company accounts for stock-based employee compensation arrangements
using the intrinsic value method in accordance with the provisions of
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees (APB No. 25) and complies with the disclosure provisions of
Statement of Financial Accounting Standards No. 123, Accounting for
Stock-Based Compensation (SFAS No. 123). Under APB No. 25, compensation
expense is the excess, if any, of the fair value of the Company's stock at
a measurement date over the amount that must be paid to acquire the stock.
As of December 31, 2002 the Company adopted the disclosure requirements of
SFAS 148, Accounting for Stock Based Compensation, which amends accounting
principals Board ("APB") No. 28 by adding to the list of disclosures to be
made for interim periods.
SFAS No. 123 requires a fair value method to be used when determining
compensation expense for stock options and similar equity instruments. SFAS
No. 123 permits a company to continue to use APB No. 25 to account for
stock-based compensation to employees, but pro forma disclosures of net
income and earnings per share must be made as if SFAS No. 123 had been
adopted in its entirety. For purposes of pro forma disclosures, the
estimated fair value of the options is amortized over the options' vesting
period. Stock options issued to non-employees are valued under the
provisions of SFAS No. 123. Had compensation cost for the Company's options
been determined based on the methodology prescribed under SFAS No. 123, the
Company's net income and income per share would have been as follows:
For the three For the nine
months ended months ended
September 30, September 30,
2004 2003 2004 2003
---- ---- ---- ----
Net income for the period $3,611,000 $3,020,000 $10,841,000 $8,211,000
Compensation expense,
net of tax effect 18,000 38,000 55,000 113,000
---------- ---------- ----------- ----------
Pro-forma net income $3,593,000 $2,982,000 $10,786,000 $8,098,000
========== ========== =========== ==========
Pro-forma earnings
per common share $0.36 $0.32 $1.11 $0.89
Pro-forma earnings per
common share, assuming
dilution $0.32 $0.28 $0.97 $0.78
The fair value of each option is estimated on date of grant using the
Black-Scholes option-pricing model with the following weighted-average
assumptions (no options were granted in 2003):
2004
----
Dividends 5%
Expected volatility 26.8%
Risk-free interest rate 2.57%
Expected life 3 years
Note 4 - Comprehensive Income
The Corporation's total comprehensive earnings presentation is as follows:
(in thousands)
For the three months For the nine months
ended September 30, ended September 30,
2004 2003 2004 2003
---- ---- ---- ----
Net Income $3,611 $3,020 $10,841 $8,211
Other Comprehensive income (loss):
Change in unrealized holding gain
(losses) during the period 9 (4) (14) (8)
Income tax benefit (expense) (4) 2 5 3
------ ------ ------- ------
5 (2) (9) (5)
------ ------ ------- ------
Comprehensive income $3,616 $3,018 $10,832 $8,206
====== ====== ======= =======
Note 5 - Subsequent Event
The Board of Directors reviewed the status of option grants for non-officer
directors. While the Board believes these grants have served their purpose
of aligning the directors' interests with those of the Company's other
shareholders, the strong performance of the Company's stock since 2001 (the
last time options were granted to directors) has resulted in options having
a higher dilutive impact than originally anticipated. Accordingly, as of
November 5,2004, each non-officer director has determined to cancel those
options he held as of January 1, 2004, and any non-officer director who
exercised options earlier in 2004 is either unwinding the exercise or
contributing additional capital by paying the market price at the time for
the shares he received. The Board unanimously decided that this action
would benefit all shareholders and would best position the Company to take
advantage of the opportunities that lie ahead. Although he is no longer a
board member, William Gallaher, who resigned as a director on October 13,
2003, has also participated in this action by paying the market price at
the time the options were exercised. The Board intends to engage a
consultant to help design a compensation package for the outside directors.
The effect of these actions will be to (1) reduce the number of fully
diluted shares of the Company and thereby increase our fully diluted
earnings per share and (2) increase our shareholders' equity by $3.7
million as the net result of unwinding option exercises which occurred
earlier in 2004 offset by payments of the market price differential.
Had these events occurred prior to October 1, 2004, the pro forma effect of
these actions on our earnings per common share assuming dilution would have
been as follows:
Three months ended Nine months ended
September 30, September 30,
2004 2003 2004 2003
---- ---- ---- ----
Shares including dilutive
securities (as reported) 11,290,064 10,486,574 11,143,422 10,513,369
Shares including dilutive
securities (pro-forma) 10,258,669 9,505,237 10,120,796 9,511,583
Earnings per common
share assuming
dilution (as reported) $0.32 $0.29 $0.97 $0.78
Earnings per common
share assuming
dilution (pro forma) $0.35 $0.32 $1.07 $0.86
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Northern Empire Bancshares (the "Corporation") is the bank 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.
Critical Accounting Policies
The Corporation and Bank's accounting policies are fundamental to
understanding management's discussion and analysis of results of operations
and financial condition. One policy, Allowance for Loan Losses, has been
identified as being critical because it requires management to make
difficult and subjective judgments about matters that are inherently
uncertain and because of the likelihood that materially different amounts
would be reported under different conditions or using different
assumptions. This policy is reviewed by the Loan Committee and approved by
the Board of Directors.
The Allowance for Loan Losses represents management's estimate of probable
losses inherent in the loan portfolio at the balance sheet date. The
allowance for loan losses is reviewed monthly and is based on allocations
for each loan category (e.g. Real Estate, Commercial) plus an allocation
for any outstanding loans which have been classified and are on the "Watch
List." Each loan that has been classified is individually analyzed for the
risk involved and an allowance provided according to the risk assessment.
In addition to the allocated component there is an unallocated component.
The unallocated component incorporates management's judgment of the
inherent risks in the portfolio based on: historical loan loss experience,
loan concentrations, evaluations made by regulatory agencies and our
outside consultants, and assessment of economic conditions. The allocated
and unallocated components represent the total allowance for loan losses
that management estimates is adequate to cover losses inherent in the loan
portfolio.
Changes in the estimate related to the allowance for loan losses can
materially affect net income. The process of determining the allowance
requires us to make assumptions which are highly uncertain, and requires a
high degree of judgment; and is impacted by regional, national and global
economic trends. Different assumptions regarding possible future economic
conditions could have been used and would have had a material impact on the
provision for loan losses and on the consolidated results of operations.
Forward-looking statements
The discussion of certain matters in this report may constitute
"forward-looking statements," as defined in Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act, which includes
statements such as projections, plans, objectives and assumptions about the
future, and such forward looking statements are subject to the safe harbor
created by these sections. Although the Corporation and the Bank have
based their plans and projections on certain assumptions, there can be no
assurances that such assumptions will be correct, or that such plans and
projections can be achieved. Many factors, risks and uncertainties could
cause the actual results, amounts or events to differ materially from those
the Corporation and the Bank expect to achieve or occur. Such factors,
risks and uncertainties include, but are not limited to, the following:
* Changes in the market interest rates and volatility of rate sensitive
loans and deposits.
Changes in interest rates impact the demand for new loans, the rates
received on loans and securities and the rates paid on deposits and
borrowings. Significant fluctuations in interest rates may have an
adverse effect on the business, financial condition and results of
operations of the Corporation and the Bank.
* Competitive pressures in the banking industry.
The banking business is highly competitive, and competition among
financial institutions for all types of financial products and services
is expected to increase. The ability of the Bank to compete in the
future will depend on the nature and level of future competition.
* Changes in the legislative and regulatory environment.
Banks and bank holding companies are subject to extensive supervision
and regulation. The banking business is also affected by the monetary
and fiscal policies of the United States government and the Federal
Reserve Board. The future regulatory environment may significantly
affect the Bank's business.
* Declines in the national or regional economy.
A worsening of economic conditions could reduce the demand for loans,
cause credit quality deterioration and/or result in a decline in the
value of real estate collateral securing a substantial portion of the
Bank's loans. Any of these factors could have an adverse impact on the
Bank's financial condition.
* Changes in accounting standards by the Financial Accounting Standards
Board, the Securities and Exchange Commission (SEC) or other
standard-setting bodies.
Such changes could affect the manner in which the Corporation and the
Bank are required to account for and report income, expenses, reserves,
or a merger or acquisition, if any, and could materially affect the
Corporation's business and financial statements.
* Changes in the U.S. Small Business Administration program.
The Bank makes a significant portion of its commercial loans through
the U.S. Small Business Administration program, which guarantees a
portion of such loans, and the Bank generates income through the sale
of such loans. Changes in the Small Business Administration program
could have an adverse effect on the Bank's business.
* Changes in Federal Home Loan Bank (FHLB) borrowing policies.
The Bank relies upon the FHLB for a large portion of the funding
which is collateralized by loan assets. Based upon the current
policies of the FHLB we believe the advances are renewable. Changes in
the requirements of the FHLB could materially affect the Bank's
business and financial statements.
Investors are cautioned to consider these and other risks and
uncertainties.
The Corporation specifically disclaims any obligation to update any such
factors or to publicly announce the results of any revisions to any
forward-looking statements in this report to reflect future events or
developments.
Summary of Financial Results
Total consolidated assets equaled $1,028.1million at September 30, 2004
compared to $848.2 million at December 31, 2003. Net loans increased $136.2
million since year-end with $45.7 million occurring in the third quarter.
Cash and equivalents increased $21.0 million during the third quarter.
Deposits increased $57.0 million and FHLB advances increased $5.7 million
during the third quarter.
The net income after tax for the first nine months of 2004 equaled
$10,841,000 compared to $8,211,000 for the comparable period of 2003, an
increase of 32.3%. The net income for the third quarter of $3,611,000
increased 19.6% over the third quarter of 2003 when net income equaled
$3,020,000. Increased profit resulted from growth in net interest income
due to loan growth and the lower cost of funds resulting from the decision
to borrow on its credit line with the Federal Home Loan Bank.
Net Interest Income
Net interest income (before the provision for loan losses) of $9,980,000
for the third quarter of 2004 increased 25.2% from $7,969,000 for the
comparable period last year. This increase in net interest income resulted
primarily from volume increases of $213.2 million in average earning assets
for the current quarter compared to the third quarter of 2003. The Bank
experienced a $194.3 million increase in average loans outstanding, which
have the highest yields. Average investments, interest-bearing cash
balances and Fed Funds investments increased $18.9 million. Average
interest bearing deposits for the third quarter increased $78.1 million
over the same period last year and average borrowings with the Federal Home
Loan Bank increased $66.7 million.
The net interest margin equaled 4.14% during the third quarter of 2004
compared to an average margin for the third quarter of 2003 of 4.24% and
4.25% for the year ended December 31, 2003. The yield on average loans
equaled 6.29% in the third quarter compared to 6.69% for the same period
last year, while the Bank(s cost of funds decreased to 1.99% for the third
quarter of 2004 from 2.12% for the third quarter of 2003.
Several factors impact the Bank(s interest margin. These include changes in
market interest rates, level of loans relative to deposits, mix of loan and
earning assets, non-accrual loan balances and mix of deposits and other
funding sources.
* Changes in Market Interest Rates
Changes in economic conditions and actions of the 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 2003 prime rate equaled 4.25% until June 30, 2003
when it declined to 4.00%, a 40 year low, where it remained until June 30,
2004. Prime rate increased three times since then to 4.75% at the end of
the current quarter. Until recently, the prime rate had remained fairly
stable following 2001 when Fed Funds and Prime rates declined 11 times with
Prime declining from 9.50% to 4.00%. The majority of the Bank's SBA loans
is tied to prime rate and reprice on a quarterly basis, based on the
published prime rate on the last day of the preceding calendar quarter. The
25 basis point increase in prime rate on June 30, 2004 impacted SBA 7(a)
loans on July 1, 2004 with the additional increase in prime of 50 basis
points impacting the SBA loans effective October 1, 2004. Other loan
indexes generally move with, precede or lag changes in prime rate. 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 Bank is considered asset sensitive, meaning more assets are immediately
adjustable than liabilities. The Bank's net interest margin tends to
increase when interest rates increase and tends to decrease in a declining
rate environment.
The full impact of rate changes on the Bank's earnings are not realized for
several months, since not all loans or deposits reprice immediately. As of
September 30, 2004, the Bank has $211.8 million in SBA 7(a) loans which
reprice based upon the prime rate on the first day of the calendar quarter.
The Bank also has $253.3 million in adjustable rate loans, mainly
commercial real estate loans, which are tied to the Eleventh District Cost
of Funds Index (COFI) which adjust at a slower pace. The COFI index was
1.875% for August 2004 (latest available) and 1.90% for December 2003
compared to 2.38% for December 2002. The Bank also has a fixed rate loan
portfolio which generally reduces net interest margin as interest rates
rise and benefits net interest margin as rates decline. The rate of loan
prepayments continues at an increased rate as borrowers refinance to
indexes which bear lower rates than loans tied to COFI which are at floors
or fixed rates.
Of the Bank's loan portfolio totaling $879.3 million at September 30, 2004,
$392.5 million or 44.6% of total loans are adjustable rate loans which have
not reached a floor or ceiling rate. Of that total approximately $275.8
million are prime-based loans, of which $64.0 million reprice immediately
and $211.8 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 make them
less attractive to depositors. The Bank continues to experience a
moderately high level of loan payoffs with borrowers refinancing to loans
tied to indexes which bear lower rates than loans tied to COFI or loans at
floors or fixed rates and to taking advantage of equity in the market
values of the underlying collateral.
Interest rates offered on certificates of deposits have increased with the
recent increase in market rates, yet they remain at low levels,
historically. The Bank has $130.0 million in Sonoma Investor Reserve
accounts (money market rate deposit accounts). The cost of these deposits
equaled 1.08% during both the third quarter of 2004 and the third quarter
of 2003.
The Bank has $518.9 million in time certificates of deposits. These
accounts reprice at a slower pace. The cost of time deposits equaled 2.48%
for the third quarter of 2004 compared to 2.79% in the third quarter of the
preceding year. With the increase in market rates the cost of time deposits
will increase when they mature and are renewed at the higher market rates
offered on their maturity dates. The Bank continues to offer 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 increased to an average of 114% in
the third quarter of 2004 compared to 105% for the same period last year.
An increase in the loan-to-deposit ratio generally results in an increase
in net interest margin.
* Mix of Loan and Earning Assets
Changes in the mix of loans also impact the Bank's net interest margin.
The largest loan growth occurred in real estate mortgage loans growing to
$605.0 million at this quarter end from $495.5 million at December 31,
2003. This category has a lower yield than other types of loans. The Bank
has developed new loan products tied to US Treasury and LIBOR index with
other favorable terms to attract new loan volume. Loan volume has
increased as a result of these new products and the Bank's competitive rate
structure. Total COFI loans have declined; however, they remain a popular
index in our market especially in a rising rate environment, since the
index lags from other indexes like prime rate and LIBOR.
Construction loans increased to $38.8 million at the end of this quarter
from $26.3 million at year end. Construction loans generally have higher
yields than other real estate loans. General economic conditions greatly
influence the demand for construction loans and the Bank has experienced an
increase in activity during this quarter.
SBA loans, which generally are secured by real estate, are classified as
commercial loans. Commercial loans totaled $229.4 million at September 30,
2004 compared to $214.0 million at December 31, 2003, of which $211.8
million and $162.7 million, respectively, were 7(a) SBA loans. SBA loans
continue to be a popular loan product; however, the SBA loan program was
impacted by federal government budgetary issues during the first quarter of
2004. On April 5, 2004 government funding was restored for the SBA's 2004
fiscal year, the loan cap was lifted and the program was increased to allow
for guaranteed loans up to $2 million which provides a better loan product
for borrowers. Additional government actions may further alter the SBA
program, could have a negative impact on the Bank's profits.
Economic conditions and competition have impacted the mix of loans.
Refinancing of COFI loans due to the higher floor rate than current rates
has reduced loan yields. The Bank is currently offering loan products tied
to prime rate, U.S. Treasury rates or LIBOR which have lower interest rates
but reprice at a faster rate than COFI loans. Construction loans have some
seasonality and generally rise when economic conditions improve. The Bank
continues to experience strong competition for loans, which has resulted in
lower loan pricing in the market place, which impacts the Bank(s offering
rates on new loans and negatively impacts the Bank(s net interest margin.
* 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
September 30, 2004 the Bank had $520,000 in non-accrual loans compared to
$1,274,000 million at December 31, 2003. 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. 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 impact of changes in interest rates. Sonoma Investor Reserve
accounts can be repriced weekly; and therefore, the benefit of falling
interest rates and the negative impact of rising rates are more immediate.
Competition also is a factor in the repricing of certain deposit products.
While prime rate changes have a more immediate impact on loans it may take
longer for the impact in repricing market rate deposits due to competition
for these deposits in our market area.
The Bank also has a borrowing line with the Federal Home Loan Bank (FHLB)
which has been used as a source of liquidity. Based on the present terms
and conditions of the FHLB line of credit, the borrowing rates are below
rates offered on certificates of deposits and the Bank has increased the
use of this line as a way to reduce our cost of funds. As of September 30,
2004 the Bank had increased borrowed funds from the FHLB to $161.9 million
as compared to $79.2 million at September 30, 2003, an increase of $82.7
million. The cost of borrowing was consistently more than 50 basis points
below the current offering rate on deposits of similar term.
Interest expense increased to $3,924,000 in the third quarter of 2004 from
$3,423,000 in the third quarter of 2003. The major factor was the increase
in deposits and FHLB advances. The average cost of interest bearing
liabilities declined to 1.99% from 2.12% when comparing the third quarter
of this year to the third quarter of last year, which had a positive impact
on interest expense during the quarter. The increase in the funds borrowed
from the FHLB to fund loan growth at an average rate of 1.58% also had a
positive impact rather than attracting new deposits at market rates.
The following are analyses of the net interest margin:
Three months ended Three months ended
September 30, 2004 September 30, 2003
(dollars in thousands)
Average Average
Balance Interest Yield Balance Interest Yield
-------- -------- ----- -------- -------- -----
Earning assets (1) $958,783 $13,904 5.77% $745,590 $11,391 6.06%
Interest bearing
liabilities 785,862 3,924 1.99% 641,090 3,423 2.12%
------- -------
Net interest income $ 9,980 $ 7,969
======= =======
Net Interest income
to earning assets 4.14% 4.24%
==== ====
(1) Non-accrual loans are included in the calculation of average balance
of earning assets, and interest not accrued is excluded.
Nine months ended Nine months ended
September 30, 2004 September 30, 2003
(dollars in thousands)
Average Average
Balance Interest Yield Balance Interest Yield
-------- -------- ----- -------- -------- -----
Earning assets (1) $904,800 $39,363 5.81% $706,112 $33,069 6.26%
Interest bearing
liabilities 785,891 10,732 1.82% 608,044 10,612 2.33%
------- -------
Net interest income $28,631 $22,457
======= =======
Net Interest income
to earning assets 4.23% 4.25%
==== ====
(1) Non-accrual loans are included in the calculation of average balance
of earning assets, and interest not accrued is excluded.
The following tables 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 nine months ended September 30, 2004 and
2003. Changes not solely attributable to rate or volume have been
allocated to rate.
For the three months ended September30, 2004
over September 30, 2003
(dollars in thousands)
Volume Yield/Rate Total
------- ------- -------
Increase (decrease) in interest income:
Portfolio loans $10,050 ($7,666) $2,384
Other earning assets 256 (128) 128
Total increase (decrease) 10,306 (7,794) 2,512
------- ------- -------
Increase (decrease) in interest expense:
Interest-bearing transaction accounts (10) 11 1
Time deposits 1,558 (1,407) 151
Other borrowings 731 (382) 349
------- ------- -------
Total increase (decrease) 2,279 (1,778) 501
------- ------- -------
Increase (decrease) in net
interest income $8,027 ($6,016) $2,011
======= ======= =======
For the nine months ended September 30, 2004
over September 30, 2003
(dollars in thousands)
Volume Yield/Rate Total
------- ------- -------
Increase (decrease) in interest income:
Portfolio loans $12,677 ($6,585) $6,092
Other earning assets 328 (126) 202
------- ------- -------
Total increase (decrease) 13,005 (6,711) 6,294
------- ------- -------
Increase (decrease) in interest expense:
Interest-bearing transaction accounts 62 (181) (119)
Time deposits 2,862 (3,310) (448)
Other borrowings 1,123 (436) 687
------- ------- -------
Total increase (decrease) 4,047 (3,927) 120
------- ------- -------
Increase (decrease)
in net interest income $8,958 ($2,784) $6,174
======= ======= =======
Provision for Loan Losses
The provision for loan losses equaled $475,000 for the three months ended
September 30, 2004 and $1,025,000 for the first nine months of 2004
compared to $150,000 and $750,000 for the same periods in 2003. The
provision was based upon the overall growth in loans at the end of the
current quarter. 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 $965,000 from $758,000 when comparing the third quarter of
2004 to the same period last year primarily as a result of a higher volume
of SBA loan sales this quarter. Year to date income increased to
$2,547,000 from $2,177,000 due to the increase in gains on SBA loans sales
during 2004.
* Service Charges
Service charges on deposit accounts equaled $96,000 in the third quarter of
2004 compared to $138,000 for the same period last year. The decrease is
partially the result of the higher earnings credit rate of 2.50% on
analysis accounts which went into effect in September of 2003 and has
remained rather than declining as the market rates declined. This rate was
to assist in attracting new analysis customers during a period of low
rates. Analysis customers earn less on their average balances to cover the
cost of services provided to them. If the earnings credits earned do not
cover the cost of services, the customer is charged a service fee.
Analysis customers can increase their average balances to reduce the
charges or alter the services provided to reduce their service charges. The
Bank also receives fees for safe deposit, merchant credit cards, and other
services.
* SBA Loan Sales and Loan Participations
In the third quarter of this year, the Bank sold the guaranteed portion of
SBA loans totaling $5.3 million with no loan participations and recognized
gains on those sales of $594,000. During the third quarter of last year,
the Bank sold the guaranteed portion of SBA loans totaling $3.5 million
with no participations and recognized gains on those sales of $352,000. 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 average
percentage gain on loan sales received in the third quarter of 2004
remained strong equaling 11.3% compared to 10.1% in the third quarter of
2003. Premiums on loan sales are market driven based upon factors such as
rate of prepayments of SBA loans experienced throughout the country and
there is no guarantee that premiums will continue at the current level.
* SBA Loan Servicing
SBA servicing fees totaled $114,000 during the third quarter of 2004,
compared to fees of $98,000 recorded in the third quarter of last year. The
income varies since the fee income is calculated based upon the payments
received during the period and the size of the portfolio serviced. The
serviced portfolio equaled $55.4 million at September 30, 2004 compared to
$47.5 million at September 30, 2003.
* Sales of Other Real Estate Owned
There were no sales of other real estate owned (OREO) during the third
quarter of 2004 and there was a gain of $183,000 recorded on the sale of
foreclosed property during the first quarter of 2004. There were no sales
of OREO during the first nine months of 2003.
Non-Interest Expenses
The Bank(s non-interest expenses totaling $4,356,000 in the third quarter
of 2004 increased 20.6% from $3,612,000 for the third quarter of last year.
It was expected that non-interest expenses would increase in the third
quarter of 2004 as a result of the new branch in San Rafael, expansion of
the Bank's operations center and the relocation of the lending functions to
larger premises. Non-interest expenses for the nine months ended
September 30, 2004 increased to $11,847,000 from $10,282,000 for the same
period in 2003. This increase results from growth throughout the Bank
which has impacted most expense categories especially personnel costs
associated with increased staffing and occupancy costs due to additions to
Bank facilities.
* Salaries and Employee Benefits
The Bank's largest expense category is salaries and benefits which
increased 18.4% to $2,711,000 in the third quarter of 2004 from $2,289,000
during the third quarter of 2003. The Bank(s full time equivalent (FTE)
staff level has increased to 151 in September 2004 compared to 129 in
September 2003. Increased staff included a branch staff for San Rafael
office, new regional loan officer in Sacramento, and additional staff in
the Credit , Loan Servicing, Branch Administration, Finance, Internal Audit
and Compliance. Personnel costs are also affected by annual salary
increases, incentives based upon production goals and changes in benefit
costs. Incentive payments remained high due to the increased level of loan
production during the third quarter of 2004.
* Occupancy and Equipment
Occupancy expenses increased to $364,000 in the third quarter of 2004 from
$312,000 in the third quarter of 2003. This increase results from several
changes in premises. The Loan Department and several administrative
functions were relocated to Fountaingrove Business Center in northern Santa
Rosa in the second quarter. This space was designed to provide operational
efficiencies and to provide for expansion. The operations center also
completed its expansion and the new San Rafael Branch opened on July 28.
Many of the occupancy costs associated with this expansion commenced during
the third quarter of this year. It is expected that occupancy expenses
will continue to increase as and if the Bank continues to expand. Equipment
costs of $266,000 increased 27.9% over $208,000 in the third quarter last
year. The Bank has upgraded the mainframe and added imaging equipment to
meet the needs of our customers and continues to replace obsolete equipment
and upgrade equipment where appropriate. It is expected that equipment
costs will continue to increase as the Bank expands.
* Deposit and Other Insurance
Deposit and other insurance of $121,000 increased $28,000 over the third
quarter of last year. Regulatory assessments and FDIC insurance cost grew
due to the increase in deposits. There is no assurance that regulatory
assessments will continue at the current low level. The cost of other
insurance also increased when three year policies expired and renewed with
higher rates and increased insurance coverage.
* Professional Services
Professional fees of $161,000 increased from $62,000 for the third quarter
of 2003. Included in this category are legal, accounting and consulting
fees which tend to vary depending upon the timing and need for services.
There continues to be increased legal, consulting and accounting costs in
connection with SEC reporting and the new regulations resulting from the
Sarbanes Oxley Act. Legal activity varies with the third quarter charges
higher than normal due to a review of the Company's stock options. Legal
costs associated with problem loans were minimal during this quarter due to
the low level of problem loans (see discussion on Allowance for Loan
Losses). Audit or review services are contracted by the Audit Committee
and are performed on a varying schedule with a significant amount of
activity during this quarter to perform the review of internal controls
mandated by new SEC regulations. It is expected that Consulting and Audit
fees will continue to increase as a result of SEC changes which include new
requirements on internal controls. The Bank hired an independent
consultant to assist in performing an evaluation and test the Bank's system
of internal controls and operating procedures as called for under the new
rules.
* Advertising and Business Development
Advertising and business development costs, which vary depending on loan
and deposit promotions, increased to $168,000 from $155,000 in the third
quarter of 2003. These costs are expected to increase due to the
geographic markets that the new branches are entering.
* Outside Customer Services
Outside customer services were $100,000 as compared to $89,000 in the third
quarter of 2003. The Bank pays for certain direct costs (i.e.: payroll
services, escrow fees, etc.) which are expensed. These costs are based
upon depositor's use of the analysis system. 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. There has been some growth
in analysis customers which is reflected in the increased expense.
* Shareholder and Director Expenses
Third quarter expenses for shareholder and director expenses equaled
$127,000 compared to $100,000 for the third quarter of last year. Included
in this category are directors' fees for attending Board, Loan Committee,
ALCO, Executive Committee, Audit and special director meetings. There have
been changes to the Board of Directors with the resignation of one director
who served on several committees. Two directors were added to the Board
and fees increased as a result. The activity of the Audit Committee has
also increased as a result of new SEC regulations. The cost of the
Corporation(s annual report, transfer agent fees and other costs of
communicating with shareholders is also included in this expense category
and these costs have also increased and are expected to continue to
increase.
* Other Expenses
Other expenses, which include stationery and supplies, telephone, postage,
armored car and courier costs, loan expenses, dues and subscriptions and
automobile costs increased to $338,000 from $304,000 in the third quarter
of 2003. Many of these expenses vary depending upon the current activity.
Miscellaneous loan expenses can vary significantly depending on the level
of problem loans or the need to outsource inspections. It is expected that
these costs will increase as a result of the Bank's growth.
Income Taxes
The effective tax rate was 40.9% for the third quarter of 2004. The
provision for the third quarter of 2004 was $2,503,000 versus $1,945,000
for the same period last year. This increase resulted from increases in
pre-tax income during the comparable quarters. The effective tax rate is
affected by several factors which include apportionment ratios between
states, the enterprise zone deduction and applicable tax rates.
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.
Operating activities provided cash totaling $13.3 million during the nine
months ended September 30, 2004. The Bank invested $136.1 million in loans
during the nine months ended September 30, 2004. The Bank increased funds
through deposits by $119.6 million and borrowed $42.7 million from the
Federal Home Loan Bank during the nine months ended September 30, 2004.
Cash and due from banks, federal funds sold and certificates of deposit
totaled $132.4 million or 12.9% of total assets at September 30, 2004,
compared to $94.6 million or 11.1% of total assets at December 31, 2003.
The Bank sold $5.3 million in SBA loans during the third quarter of 2004
which increased the Bank(s liquidity. The Bank also increased borrowings
from the Federal Home Loan Bank by $5.7 million during the third quarter of
2004. Bank deposits increased $57.0 million during the third quarter of
2004 as a result of deposit promotions. The funds provided by all of these
actions were used to fund loan growth.
The Bank considers the unsold guaranteed portion of 7(a) SBA loans as a
secondary source of liquidity. There is an established market for these
loans and a sale can be completed within a few weeks. As of September 30,
2004, the Bank held $142.6 million in SBA guaranteed loans which could be
sold for additional liquidity.
At September 30, 2004, the Bank had unused federal funds lines of credit
totaling $26,000,000. 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). As of September 30, 2004 the Bank has collateral pledged which
would allow the Bank to borrow up to $243.1 million from the FHLB. The
Bank could borrow an amount equal to 35% of our assets, assuming that
collateral values would support that level of borrowings. At September 30,
2004, the Bank had borrowed $161.9 million with $81.2 million still
available to borrow with the FHLB. 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
September 30, 2004, the Corporation had non-interest and interest bearing
cash balances of $4.1 million, 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 third quarter of 2004, deposits increased to $777.9 million
compared to $658.3 million at the end of the year.
Money market deposits totaling $130.0 million decreased $11.2 million from
$141.2 million at December 31, 2003 . This is a limited transaction
account with a discretionary rate which is set by management. The rate
offered on this account has been relatively unchanged during this quarter
even though there is strong competition in our market area for these types
of funds. The Bank(s customers continue to hold funds in this deposit
product rather than locking into a specific maturity during this time of
low interest rates. These funds are also more volatile and fluctuate
during various business cycles.
Certificates of deposits totaling $518.9 million at September 30, 2004
increased 28.4% from $404.0 million at December 31, 2003. The Bank offered
time deposit promotions during this quarter which were successful in
attracting new depositors. The new branch in San Rafael has also been
successful in recording new time deposits.
As of September 30, 2004, non-interest bearing deposits equaled $82.7
million compared to $61.4 million at December 31, 2003. The Bank(s
transaction accounts have significant changes in daily balances, mainly due
to deposits held by large businesses' accounts.
The interest rate environment 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 $870.1 million at September
30, 2004 compared to $733.9 million at December 31, 2003, increasing 18.6%
over year end and 30.2% over the September 30, 2003 balance of $668.1
million. The following is an analysis of the loan portfolio.
Type of Loan (in thousands) September 30, December 31,
2004 2003
---- ----
Real estate-mortgage $604,981 $495,538
Real estate- construction 38,774 26,271
Commercial 229,448 214,000
Consumer installment 6,047 6,185
-------- -------
879,250 741,994
Deferred loan fees and discounts (972) (838)
Allowance for loan losses (8,194) (7,299)
-------- --------
Total $870,084 $733,857
======== ========
The SBA loan program continues to be a popular program; however,
competition remains very strong in our market areas. At September 30, 2004,
total SBA (7a) loans equaled $211.8 million, net of $55.4 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, they are reported as commercial
loans. SBA loans have the same underwriting requirements as the Bank(s
other loans, except 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 government program could
affect the Bank(s profitability and future SBA loan growth. The guaranteed
portion of SBA loans which could be sold in the secondary market was $142.6
million at September 30, 2004 compared to $117.5 million at September 30,
2003.
The Bank continues to emphasize commercial and real estate lending. At
September 30, 2004, 26.1% of the loans held for investment were commercial
loans and 73.2% were real estate and construction loans, compared to 28.8%
and 70.3% respectively at December 31, 2003. The Bank has continued to
grow its commercial and commercial real estate portfolio through its
reputation as an experienced business and real estate lender which
facilitates the successful negotiation of complex commercial loans. Most
of our real estate loans have 60-75% loan-to-value ratios at the time that
they are originated by the Bank. 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, a
worsening of economic conditions or a natural disaster could potentially
have an adverse impact on the value of collateral, on the loan portfolio,
and on the financial condition of the Bank.
Construction loans increased to $38.8 million at September 30, 2004 from
$26.3 million at December 31, 2003 due to the improved demand caused by
general economic conditions. 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 0.7% of the total loan
portfolio at September 30, 2004 and 0.8% of the total loan portfolio at
December 31, 2003
Allowance for Loan Losses
The allowance for loan losses equaled $8,194,000 at September 30, 2004,
compared to $7,299,000 at December 31, 2003. At September 30, 2004, the
allowance for loan losses equaled 1.1% 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 September 30, 2004, there were three borrowers on non-accrual totaling
$520,000 with all, of that amount collateralized by real estate and
$198,000 of it also guaranteed by the SBA. There were no loans past due 90
days or more and still accruing interest. Loans past due 30 to 89 days
totaled $5,407,000, with $5,394,000 of that amount collateralized by real
estate. At December 31, 2003, the Bank had $1,274,000 in non-accrual loans
and no loans past due 90 or more days and still accruing interest. Past due
30 to 89 days totaled $1,950,000 at December 31, 2003.
During the third quarter of 2004, there were no loans charged off and less
than $500 in loan recoveries. The Bank continues to have a low charge off
experience compared to industry standards but there can be no assurances
that this will continue or that the Bank will not experience loan losses.
The following is an analysis of the activity in the allowance for loan
losses during the third quarter and the first nine months of 2004:
(in thousands)
Three months ended Nine months ended
September 30, 2004 September 30, 2004
------------------ ------------------
Balance- Beginning of period $7,719 $7,299
Provision for loan losses 475 1,025
Charge offs - 135
Recoveries - 5
------ ------
Balance- End of period $8,194 $8,194
====== ======
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 September 30, 2003,
the Bank was considered "well capitalized." The total risk-based capital
ratios were 11.3% for the Bank and 11.8% for the Corporation.
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 of 100 and 200 basis
points. 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 100 and 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 next twelve months, given a change in general interest rates
of 100 and 200 basis points up or down.
Change in Estimated Estimated Change in
Interest Rate Net Interest Income Net Interest Income
(basis points) (in thousands) (in thousands)
+200 $39,530 $970
+100 39,408 424
Base Scenario 38,984 0
-100 38,791 (193)
-200 38,609 (375)
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
September 30, 2004 of assets, liabilities and shareholders' equity
classified by earliest possible repricing opportunity or maturity date.
Balance Sheet
(in thousands)
Assets
Over 3 Over Non-rate
Through months 1 year Sensitive
3 through through or Over
months 1 year 5 years 5 years Total
------- ------- ------- ------ ------
Fed funds sold &
certificates of deposit $106,683 $106,683
Investment securities $1,089 $8,086 9,175
Loans (net of discounts) 414,448 $193,531 261,345 8,954 878,278
Non interest-earning
assets (net of allowance
for loan losses) 33,968 33,968
-------- -------- -------- ------- ----------
$521,131 $193,531 $262,434 $51,008 $1,028,104
======== ======== ======== ======= ==========
Liabilities &
Shareholders' Equity
Time Deposits $100,000
and over $39,946 $181,050 $13,592 $234,588
All other interest-
bearing liabilities 381,605 216,694 22,326 $1,921 622,546
Non interest
bearing liabilities 82,662 82,662
Other Liabilities &
Shareholders' Equity 88,308 88,308
-------- -------- -------- ------- ----------
$421,551 $397,744 $35,918 $172,891 $1,028,104
======== ======== ======== ======= ==========
Interest Rate
Sensitivity (1) $99,580 ($204,213) $226,516 $121,883
Cumulative Interest
Rate Sensitivity $99,580 ($104,633) $121,883 $0
(1) Interest rate sensitivity is the difference between interest rate
sensitive assets and interest rate sensitive liabilities within the above
time frames.
ITEM 4. Controls and Procedures
As of the end of the period covered by this report, the Corporation carried
out an evaluation, under the supervision and with the participation of the
Corporation's management, including its Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of the
Corporation's disclosure controls and procedures, as defined in Securities
Exchange Act Rule 15d-14 (e). Based on that evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that the
Corporation's disclosure controls and procedures are effective in a timely
manner to alert them to material information relating to the Corporation
which is required to be included in the Corporation's periodic Securities
and Exchange Commission filings. No change in internal control over
financial reporting, as defined in Securities and Exchange Act Rule
15d-15(f), occurred during the fiscal quarter ended September 30, 2004 that
has materially affected or is reasonably likely to materially affect the
Corporation's internal control over financial reporting.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings - None other than in the ordinary course of
business.
Item 2. Changes in securities, use of proceeds and issuer of purchases of
equity securities - None
Item 3. Defaults Upon Senior Securities - None
Item 4. Submission of Matters to a Vote of Security Holders - None
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).
(31) Rule 13 a 14 (a)/ 15d 14(a) Certifications
(32) Section 1350 Certification
(b) Reports on Form 8-K
Form 8-K, filed on July 15, 2004, reporting, under Items 7 and 12,
second quarter of 2004 results.
Form 8-K, filed on October 18, 2004, reporting, under Items 7 and 12,
third quarter of 2004 results.
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: November 5, 2004
-----------------
/S/ Deborah A. Meekins /s/ Jane M. Baker
- ------------------------------ ---------------------------
Deborah A. Meekins Jane M. Baker
President and Chief Executive Officer Chief Financial Officer
Exhibit 31
Rule 13a - 14(a)/15d - 14(a) Certification
I, Deborah A. Meekins, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Northern Empire
Bancshares;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-(e)) for the registrant
and have:
a. designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b. evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about
the effectiveness of the disclosure controls and procedures, as of
the end of the period covered by this report based on such
evaluation; and
c. disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation of internal control over financial reporting,
to the registrant's auditors and the audit committee of registrant's
board of directors (or persons performing the equivalent functions);
a. all significant deficiencies and material weaknesses in the design
or operation of internal controls over financial reporting which
are reasonably likely to adversely affect the registrant's ability
to record, process, summarize and report financial data; and
b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls over financial reporting.
Date: November 5, 2004 Signature /s/ Deborah A. Meekins
------------------------------------------
Deborah A. Meekins, President and
Chief Executive Officer
Rule 13a - 14(a)/15d - 14(a) Certification
I, Jane M. Baker, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Northern Empire
Bancshares;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which
such statements were made, not misleading with respect to the period
covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this report, fairly present in all material
respects the financial condition, results of operations and cash flows
of the registrant as of, and for, the periods presented in this
quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15(e) and 15d-(e)) for the registrant
and have:
a. designed such disclosure controls and procedures, or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is made known
to us by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b. evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusions about
the effectiveness of the disclosure controls and procedures, as of
the end of the period covered by this report based on such
evaluation; and
c. disclosed in this report any change in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officer and I have disclosed, based on
our most recent evaluation of internal control over financial reporting,
to the registrant's auditors and the audit committee of registrant's
board of directors (or persons performing the equivalent functions);
a. all significant deficiencies and material weaknesses in the design
or operation of internal controls over financial reporting which
are reasonably likely to adversely affect the registrant's ability
to record, process, summarize and report financial data; and
b. any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal controls over financial reporting.
Date: November 5, 2004 Signature /S/ Jane M. Baker
------------------------------
Jane M. Baker, Chief Financial Officer
Exhibit 32
SECTION 1350 CERTIFICATION
The undersigned each certify that:
1. They are the duly appointed Chief Executive Officer and Chief Financial
Officer, respectively, of Northern Empire Bancshares, a California
Corporation ("the Company"); and
2. To their best knowledge and belief, the Company's Quarterly Report on
Form 10-Q for the quarter ended September 30, 2004, and to which the
Certification is attached as Exhibit 32, fully complies with the
requirements of Sections 13(a) or 15(d) of the Securities Exchange Act
of 1934 and that the information contained in the Report fairly
presents, in all material respects, the financial condition and
results of operations of Northern Empire Bancshares.
Date: November 5, 2004
/s/ Deborah A. Meekins /s/ Jane M. Baker
- ----------------------- ---------------------------
Deborah A. Meekins Jane M. Baker
President and Chief Chief Financial Officer
Executive Officer