FORM 10-Q
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2002
For Quarter Ended September 30, 2002 Commission File Number: 1.000-26099
FARMERS & MERCHANTS BANCORP
(Exact name of registrant as specified in its charter)
Delaware 94-3327828
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
121 W. Pine Street, Lodi, California 95240
(Address of principal Executive offices) (Zip Code)
Registrant's telephone number, including area code (209) 334-1101
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 [ ]
Number of shares of common stock of the registrant: Par value $0.01, authorized
2,000,000 shares; issued and outstanding 734,942 as of November 6, 2002.
FARMERS & MERCHANTS BANCORP
FORM 10-Q
TABLE OF CONTENTS
PART I. - FINANCIAL INFORMATION Page
Item 1 - Financial Statements
Consolidated Balance Sheets as of September 30, 2002,
December 31, 2001 and September 30, 2001. 3
Consolidated Statements of Income for the Three Months
and Nine Months Ended September 30, 2002 and 2001. 4
Consolidated Statements of Comprehensive Income for the Three
Months and Nine Months Ended September 30, 2002 and 2001. 5
Statement of Changes in Shareholders' Equity for the Nine
Months Ended September 30, 2002 and 2001. 6
Consolidated Statement of Cash Flows for the Nine
Months Ended September 30, 2002 and 2001. 7
Notes to Consolidated Financial Statements 8
Item 2 - Management's Discussion and Analysis 13
PART II. - OTHER INFORMATION 26
-----------------
SIGNATURES 27
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Index to Exhibits 28
2
PART I. - FINANCIAL INFORMATION
Item 1 - Financial Statements
FARMERS & MERCHANTS BANCORP
Consolidated Balance Sheets
- ----------------------------------------------------------------------------------------------------------
(in thousands) September 30, December 31, September 30,
2002 2001 2001
Assets (Unaudited) (Unaudited)
- ----------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents:
Cash and Due From $34,875 $32,406 $33,391
Federal Funds Sold 20,985 31,100 46,600
- ----------------------------------------------------------------------------------------------------------
Total Cash and Cash Equivalents 55,860 63,506 79,991
Investment Securities:
Available-for-Sale 147,092 242,852 251,117
Held-to-Maturity 28,261 32,698 32,113
- ----------------------------------------------------------------------------------------------------------
Total Investment Securities 175,353 275,550 283,230
- ----------------------------------------------------------------------------------------------------------
Loans 685,941 603,185 558,584
Less: Unearned Income (1,554) (1,016) (586)
Less: Allowance for Loan Losses (13,118) (12,709) (13,029)
- ----------------------------------------------------------------------------------------------------------
Loans, Net 671,269 589,460 544,969
- ----------------------------------------------------------------------------------------------------------
Land, Buildings & Equipment 11,307 11,432 11,643
Interest Receivable and Other Assets 41,436 30,935 12,755
- ----------------------------------------------------------------------------------------------------------
Total Assets $955,225 $970,883 $932,588
==========================================================================================================
Liabilities & Shareholders' Equity
Deposits:
Demand $184,982 $198,316 $166,128
Interest Bearing Transaction 82,707 100,574 80,058
Savings 226,567 198,651 189,847
Time Deposits 306,963 322,170 344,504
- ----------------------------------------------------------------------------------------------------------
Total Deposits 801,219 819,711 780,537
- ----------------------------------------------------------------------------------------------------------
Fed Funds Purchased/Borrowings 40,974 41,000 41,009
Other Liabilities 9,110 9,436 9,755
- ----------------------------------------------------------------------------------------------------------
Total Liabilities 851,303 870,147 831,301
- ----------------------------------------------------------------------------------------------------------
Shareholders' Equity
Common Stock 7 7 7
Additional Paid In Capital 65,464 61,360 61,392
Retained Earnings 36,089 36,499 36,063
Accumulated Other Comprehensive Income 2,362 2,870 3,825
- ----------------------------------------------------------------------------------------------------------
Total Shareholders' Equity 103,922 100,736 101,287
- ----------------------------------------------------------------------------------------------------------
Total Liabilities & Shareholders' Equity $955,225 $970,883 $932,588
==========================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
3
FARMERS & MERCHANTS BANCORP
Consolidated Statements of Income (Unaudited)
- -------------------------------------------------------------------------------------------------------------------
(in thousands) Three Months Nine Months
Ended September 30, Ended September 30,
2002 2001 2002 2001
- -------------------------------------------------------------------------------------------------------------------
Interest Income:
Interest & Fees on Loans $10,954 $11,065 $31,082 $33,808
Federal Funds Sold 55 458 385 1,560
Securities:
Investments Available-for-Sale:
Taxable 1,966 3,605 7,539 11,453
Non-taxable 241 242 718 692
Investments Held-to-Maturity:
Taxable 7 37 25 190
Non-taxable 341 381 1,054 1,214
- -------------------------------------------------------------------------------------------------------------------
Total Interest Income 13,564 15,788 40,803 48,917
- -------------------------------------------------------------------------------------------------------------------
Interest Expense:
Interest Bearing Transaction 61 159 225 507
Savings 422 957 1,562 2,827
Time Deposits 2,173 4,165 7,070 13,237
Interest on Borrowed Funds 562 570 1,668 1,680
- -------------------------------------------------------------------------------------------------------------------
Total Interest Expense 3,218 5,851 10,525 18,251
- -------------------------------------------------------------------------------------------------------------------
Net Interest Income 10,346 9,937 30,278 30,666
Provision for Loan Losses 500 150 1,000 750
- -------------------------------------------------------------------------------------------------------------------
Net Interest Income After Provision for Loan Losses 9,846 9,787 29,278 29,916
- -------------------------------------------------------------------------------------------------------------------
Non-Interest Income
Service Charges on Deposit Accounts 1,267 1,102 3,511 3,058
Net Gain (Loss) on Sale of Investment Securities - 39 276 105
Other 1,464 1,194 4,099 2,978
- -------------------------------------------------------------------------------------------------------------------
Total Non-Interest Income 2,731 2,335 7,886 6,141
- -------------------------------------------------------------------------------------------------------------------
Non-Interest Expense
Salaries & Employee Benefits 4,425 4,265 13,173 13,007
Occupancy 429 445 1,264 1,258
Equipment 502 496 1,694 1,459
Other Operating 1,796 1,745 5,526 5,021
- -------------------------------------------------------------------------------------------------------------------
Total Non-Interest Expense 7,152 6,951 21,657 20,745
- -------------------------------------------------------------------------------------------------------------------
Net Income Before Taxes 5,425 5,171 15,507 15,312
Provision for Taxes 1,980 2,009 5,680 5,949
- -------------------------------------------------------------------------------------------------------------------
Net Income $3,445 $3,162 $9,827 $9,363
===================================================================================================================
Earning Per Share $ 4.68 $ 4.19 $ 13.29 $ 12.39
===================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
4
FARMERS & MERCHANTS BANCORP
Consolidated Statements of Comprehensive Income (Unaudited)
- -------------------------------------------------------------------------------------------------------------------
(in thousands) Three Months Ended Nine Months Ended
Sept. 30, Sept. 30, Sept. 30, Sept. 30,
2002 2001 2002 2001
- -------------------------------------------------------------------------------------------------------------------
Net Income $ 3,445 $ 3,162 $ 9,827 $ 9,363
Other Comprehensive Income (Loss) -
Unrealized holding gains (losses) arising during the period, net of
income tax effects of ($234) and $980 for the quarters ended September
30, 2002 and 2001, respectively, and of ($177) and $2,167 for the nine
months ended September 30, 2002 and 2001, respectively. (479) 1,400 (348) 3,096
Less: Reclassification adjustment for realized (gains) losses included
in net income, net of related income tax effects of $0 and ($16)
for the quarters ended September 30, 2002 and 2001, respectively, and
of ($115) and ($44) for the nine months ended September 30, 2002 and
2001, respectively. - (23) (160) (61)
- -------------------------------------------------------------------------------------------------------------------
Total Other Comprehensive Income (479) 1,377 (508) 3,035
- -------------------------------------------------------------------------------------------------------------------
Comprehensive Income $ 2,966 $ 4,539 $ 9,319 $ 12,398
===================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
5
FARMERS & MERCHANTS BANCORP
Consolidated Statements of Changes in Shareholders' Equity (Unaudited)
- -------------------------------------------------------------------------------------------------------------------
(in thousands except share data) Accumulated
Common Additional Other Total
Shares Common Paid-In Retained Comprehensive Shareholders'
Outstanding Stock Capital Earnings Income Equity
- -------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2000 687,491 $ 7 $ 53,559 $ 36,527 $ 790 $90,883
===================================================================================================================
Net Income - - 9,363 - 9,363
Cash Dividends Declared on -
Common Stock - - (1,406) - (1,406)
5% Stock Dividend 33,831 - 8,288 (8,288) - -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend - - (133) - (133)
Redemption of Stock (1,924) - (455) - - (455)
Changes in Net Unrealized Gain (Loss) on
Securities Available for Sale - - - 3,035 3,035
- -------------------------------------------------------------------------------------------------------------------
Balance, September 30, 2001 719,398 $ 7 $ 61,392 $ 36,063 $ 3,825 $101,287
===================================================================================================================
- -------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2001 719,269 $ 7 $ 61,360 $ 36,499 $ 2,870 $100,736
===================================================================================================================
Net Income - - 9,827 - 9,827
Cash Dividends Declared on -
Common Stock - - (1,472) - (1,472)
5% Stock Dividend 34,501 - 8,625 (8,625) - -
Cash Paid in Lieu of Fractional
Shares Related to Stock Dividend - - (140) - (140)
Redemption of Stock (18,807) - (4,521) - - (4,521)
Changes in Net Unrealized Gain (Loss) on
Securities Available for Sale - - - (508) (508)
- -------------------------------------------------------------------------------------------------------------------
Balance, September 30, 2002 734,963 $ 7 $ 65,464 $ 36,089 $ 2,362 $103,922
===================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
6
FARMERS & MERCHANTS BANCORP
Consolidated Statement of Cash Flows (Unaudited) Nine Months Ended
- -------------------------------------------------------------------------------------------------------
(in thousands) Sept. 30, Sept. 30,
2002 2001
- -------------------------------------------------------------------------------------------------------
Operating Activities:
Net Income $9,827 $9,363
Adjustments to Reconcile Net Income to Net
Cash Provided by (Used in) Operating Activities:
Provision for Loan Losses 1,000 750
Depreciation and Amortization 1,210 1,172
Provision for Deferred Income Taxes (30) (720)
Net Accretion of Investment Securities (94) (307)
Net (Gain) on Sale of Investment Securities (378) (90)
Net Change in Operating Assets & Liabilities:
Increase in Interest Receivable and Other Assets (152) (112)
(Increase) Decrease in Interest Payable and Other Liabilities (326) 798
- -------------------------------------------------------------------------------------------------------
Net Cash Provided by (Used in) Operating Activities 11,057 10,854
Investing Activities:
Securities Available-for-Sale:
Purchased (20,113) (14,985)
Sold or Matured 115,505 48,105
Securities Held-to-Maturity:
Purchased (297) (629)
Matured 4,773 9,972
Purchase of Life Insurance Contracts (10,080) -
Net Loans Originated or Acquired (83,245) (60,855)
Principal Collected on Loans Charged Off 490 657
Net Additions to Premises and Equipment (1,085) (1,259)
- -------------------------------------------------------------------------------------------------------
Net Cash Provided by (Used by) Investing Activities 5,948 (18,994)
Financing Activities:
Net Decrease in Demand, Interest-Bearing Transaction,
and Savings Accounts (3,285) (4,157)
Increase (Decrease) in Time Deposits (15,207) 20,016
Federal Home Loan Bank Borrowings:
Advances - -
Paydowns (26) (24)
Cash Dividends (1,612) (1,539)
Stock Redemption (4,521) (455)
- -------------------------------------------------------------------------------------------------------
Net Cash Provided by (Used in) Financing Activities (24,651) 13,841
Increase (Decrease) in Cash and Cash Equivalents (7,646) 5,701
Cash and Cash Equivalents at Beginning of Year 63,506 74,290
- -------------------------------------------------------------------------------------------------------
Cash and Cash Equivalents as of Sept. 30, 2002 and Sept. 30, 2001 $55,860 $79,991
=======================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements
7
FARMERS & MERCHANTS BANCORP
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
For the nine months ended September 30, 2002 and 2001
1. Significant Accounting Policies
Farmers & Merchants Bancorp (the Company) was organized April 30, 1999. Its
primary operations are related to traditional banking activities through its
subsidiary Farmers & Merchants Bank of Central California (the Bank). The
consolidated financial statements of the Company and its subsidiary, the Bank,
are prepared in conformity with generally accepted accounting principles and
prevailing practices within the banking industry. In preparing the financial
statements, management is required to make estimates and assumptions that affect
reported amounts as of the date of the balance sheet and revenues and expenses
for the period. These estimates are based on information available as of the
date of the financial statements. Therefore, actual results could differ from
those estimates. The following is a summary of the significant accounting and
reporting policies used in preparing the consolidated financial statements.
Basis of Presentation
The accompanying consolidated financial statements include the accounts of the
Company and the Company's wholly owned subsidiary, the Bank, along with the
Bank's wholly owned subsidiaries, Farmers & Merchants Investment Corporation and
Farmers/Merchants Corp. The investment in the Bank is carried at the Company's
equity in the underlying net assets. Significant intercompany transactions have
been eliminated in consolidation. Farmers & Merchants Investment Corporation has
been dormant since 1991. Farmers/Merchants Corp. acts as trustee on deeds of
trust originated by the Bank.
Certain amounts in the prior years' financial statements have been reclassified
to conform with the current presentation. These reclassifications have no effect
on previously reported income.
Nature of Operations
The Company's primary operations are related to traditional banking activities,
including the acceptance of deposits and the lending of money through the
operations of the Bank. The Company services the northern Central Valley of
California with 18 banking offices. The area includes Sacramento, San Joaquin,
Stanislaus and Merced Counties with branches in Sacramento, Elk Grove, Galt,
Lodi, Stockton, Linden, Modesto, Turlock and Hilmar. Through its network of
banking offices, the Company emphasizes personalized service along with a full
range of banking services to businesses and individuals located in the service
areas of its offices.
Cash and Cash Equivalents
For purposes of the Consolidated Statement of Cash Flows, the Company has
defined cash and cash equivalents as those amounts included in the balance sheet
captions Cash and Due From Banks and Federal Funds Sold and Securities Purchased
Under Agreements to Resell. Generally, these transactions are for one-day
periods. For these instruments, the carrying amount is a reasonable estimate of
fair value.
Investment Securities
Investment securities are classified at the time of purchase as held-to-maturity
if it is management's intent and the Bank has the ability to hold the securities
until maturity. These securities are carried at cost, adjusted for amortization
of premium and accretion of discount using a methodology which approximates a
level yield of interest over the estimated remaining period until maturity.
Losses, reflecting a decline in value judged by the Bank to be other than
temporary, are recognized in the period in which they become known.
8
Securities are classified as available-for-sale if it is management's intent, at
the time of purchase, to hold the securities for an indefinite period of time
and/or to use the securities as part of the Company's asset/liability management
strategy. Securities classified as available-for-sale include securities which
may be sold to effectively manage interest rate risk exposure, prepayment risk,
satisfy liquidity demands and other factors. These securities are reported at
fair value with aggregate, unrealized gains or losses excluded from income and
included as a separate component of shareholders' equity, net of related income
taxes. Fair values are based on quoted market prices or broker/dealer price
quotations on a specific identification basis. Gains or losses on the sale of
these securities are computed using the specific identification method.
Unrealized losses on these securities, reflecting a decline in value judged by
the Company to be other than temporary, are recognized in the period in which
they become known.
Trading securities, if any, are acquired for short-term appreciation and are
recorded in a trading portfolio and are carried at fair value, with unrealized
gains and losses recorded in non-interest income.
Loans
Loans are reported at the principal amount outstanding net of unearned discounts
and deferred loan fees. Interest income on loans is accrued daily on the
outstanding balances using the simple interest method. Loan origination fees are
deferred and recognized over the contractual life of the loan as an adjustment
to the yield. Loans are placed on a non-accrual status when the collection of
principal or interest is in doubt or when they become past due for 90 days or
more unless they are both well-secured and in the process of collection. For
this purpose a loan is considered well-secured if it is collateralized by
property having a net realizable value in excess of the amount of the loan or is
guaranteed by a financially capable party. When a loan is placed on non-accrual
status, the accrued and unpaid interest receivable is reversed and charged
against current income, thereafter, interest income is recognized only as it is
collected in cash. Loans placed on a non-accrual status are returned to accrual
status when the loans are paid current as to principal and interest and future
payments are expected to be made in accordance with the contractual terms of the
loan.
A loan is impaired when, based on current information and events, it is probable
that the Company will be unable to collect all amounts due according to the
contractual terms of the loan agreement. When a loan is impaired, the recorded
amount of the loan in the Consolidated Balance Sheets is based on the present
value of expected future cash flows discounted at the loan's effective interest
rate or on the observable or estimated market price of the loan or the fair
value of the collateral if the loan is collateral dependent. Impaired loans are
placed on a non-accrual status with income reported accordingly. Cash payments
are first applied as a reduction of the principal balance until collection of
the remaining principal and interest can be reasonably assured.
Allowance for Loan Losses
As a financial institution which assumes lending and credit risks as a principal
element in its business, the Company anticipates that credit losses will be
experienced in the normal course of business. Accordingly, the allowance for
loan losses is maintained at a level considered adequate by management to
provide for losses that can be reasonably anticipated. The allowance is
increased by provisions charged to operating expense and reduced by net
charge-offs. Management reviews the credit quality of the loan portfolio on a
quarterly basis and considers problem loans, delinquencies, internal credit
reviews, current economic conditions, loan loss experience and other factors in
determining the adequacy of the allowance balance. The Company's methodology for
assessing the adequacy of the allowance consists of several key elements, which
include the formula allowance, specific allowances and the unallocated
allowance.
9
The formula allowance is calculated by applying loss factors to outstanding
loans and certain unused commitments. Loss factors are based on the Company's
historical loss experience and may be adjusted for significant factors that, in
management's judgment, affect the collectibility of the portfolio as of the
evaluation date. The Company derives the loss factors for loans from a loss
migration model and the historical average net charge-offs during a business
cycle.
Specific allowances are established in cases where management has identified
conditions or circumstances related to a credit that management believes
indicates the probability a loss has been incurred in excess of the amount
determined by the application of the formula allowance.
The unallocated allowance is composed of attribution factors, which are based
upon management's evaluation of various conditions that are not directly
measured in the determination of the formula and specific allowances. The
conditions evaluated in connection with the unallocated allowance may include
existing general economic and business conditions affecting the key lending
areas of the Company, credit quality trends, collateral values, loan volumes and
concentration, seasoning of the loan portfolio, specific industry conditions,
recent loss experience, duration of the current business cycle, bank regulatory
examination results and findings of the Company's internal credit examiners.
The allowance also incorporates the results of measuring impaired loans as
provided in Statement of Financial Accounting Standards (SFAS) No. 114,
"Accounting by Creditors for Impairment of a Loan" and SFAS No. 118, "Accounting
by Creditors for Impairment of a Loan-Income Recognition and Disclosures". These
accounting standards prescribe the measurement methods, income recognition and
disclosures related to impaired loans, which are discussed more fully in Note 4
of the 2001 Annual Report.
While the Company utilizes a systematic methodology in determining its
allowance, the allowance is based on estimates, and ultimate losses may vary
from current estimates. The estimates are reviewed periodically and, as
adjustments become necessary, are reported in earnings in the periods in which
they become known. Management has allocated specific reserves to various loan
categories. Nevertheless, the allowance is general in nature and is available
for the loan portfolio as a whole.
Premises and Equipment
Premises, equipment and leasehold improvements are stated at cost, less
accumulated depreciation and amortization. Depreciation is computed principally
by the straight-line method over the estimated useful lives of the assets.
Estimated useful lives of buildings range from 30 to 40 years, and for furniture
and equipment from 3 to 8 years. Leasehold improvements are amortized over the
lesser of the terms of the respective leases, or their useful lives, which are
generally 5 to 10 years. Remodeling and capital improvements are capitalized
while maintenance and repairs are charged directly to occupancy expense.
Other Real Estate
Other real estate owned, which is included in other assets, is comprised of
properties acquired through foreclosures in satisfaction of indebtedness. These
properties are carried at the lower of the recorded loan balance or their
estimated fair value, net of selling costs, based on current appraisals. Initial
losses on properties acquired through full or partial satisfaction of debt are
treated as credit losses and charged to the Allowance for Loan Losses at the
time of acquisition. Subsequent declines in value from the recorded amounts,
routine holding costs, and gains or losses upon disposition, if any, are
included in non-interest income or expense as incurred.
10
Income Taxes
As required, the Company uses the liability method of accounting for income
taxes. This method results in the recognition of deferred tax assets and
liabilities that are reflected at currently enacted income tax rates applicable
to the period in which the deferred tax assets or liabilities are expected to be
realized or settled. As changes in tax laws or rates are enacted, deferred tax
assets and liabilities are adjusted through the provision for income taxes. The
deferred provision for income taxes is the result of the net change in the
deferred tax asset and deferred tax liability balances during the year. This
amount combined with the current taxes payable or refundable results in the
income tax expense for the current year.
Earnings Per Share
The actual number of shares outstanding at September 30, 2002, was 734,963.
Basic earnings per share is calculated on the basis of the weighted average
number of shares outstanding during the period. Weighted average number of
shares for the nine months ending September 30, 2002 and 2001 were 739,417 and
755,581, respectively. Earnings per share for the nine months ending September
30, 2002 and 2001 were $13.29 and $12.39, respectively. Weighted average number
of shares for the three months ending September 30, 2002 and 2001 were 735,482
and 755,306, respectively. Earnings per share for the three months ending
September 30, 2002 and 2001 were $4.68 and $4.19, respectively. Prior periods
per share amounts have been restated for the 5% stock dividend declared during
2002 and 2001.
Dividends
Farmers & Merchants Bancorp common stock is not traded on any exchange. The
shares are primarily held by local residents and are not actively traded. A
stock dividend of $2.00 per share was declared in June 2002. In June 2001 the
per share dividend was $1.95. Additionally, a 5% stock dividend was declared in
March 2002.
Segment Reporting
The Statement of Financial Accounting Standards No. 131, "Disclosures about
Segments of an Enterprise and Related Information" requires that public
companies report certain information about operating segments. It also requires
that public companies report certain information about their products and
services, the geographic areas in which they operate, and their major customers.
The Company is a community bank which offers a wide array of products and
services to its customers. Pursuant to its banking strategy, emphasis is placed
on building relationships with its customers, as opposed to building specific
lines of business. As a result, the Company is not organized around discernible
lines of business and prefers to work as an integrated unit to customize
solutions for its customers, with business line emphasis and product offerings
changing over time as needs and demands change. Thus, all necessary requirements
of SFAS No. 131 have been met by the Company as of December 31, 2001.
Derivative Instruments and Hedging Activities
The Statement of Financial Accounting Standards, No. 133, "Accounting for
Derivative Instruments and Certain Hedging Activities" as amended by the
Statement of Financial Accounting Standards, No. 138, establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. All
derivatives, whether designated in hedging relationships or not, are required to
be recorded on the balance sheet at fair value. Changes in the fair values of
those derivatives are accounted for depending on the intended use of the
derivative and the resulting designation under specified criteria. If the
derivative is designated as a fair value hedge, the changes in the fair value of
the derivative and of the hedged item attributable to the hedged risk are
recognized in earnings. If the derivative is designated as a cash flow hedge,
the effective portions of the changes in the fair value of the derivative are
recorded in other comprehensive income and are recognized income statement when
the hedged items affect earnings. Ineffective portions of changes in the fair
value of cash flow hedges are recognized in earnings. As required, SFAS No. 133
was adopted by the Company effective January 1, 2001.
11
The Company utilizes derivative financial instruments such as interest rate
caps, floors, swaps and collars. These instruments are purchased and/or sold to
reduce the Company's exposure to changing interest rates. The Company marks to
market the value of its derivative financial instruments and reflects gain or
loss in accordance with SFAS No. 133.
Comprehensive Income
The Statement of Financial Accounting Standards, "Reporting Comprehensive
Income" establishes standards for the reporting and display of comprehensive
income and its components in the financial statements. Other comprehensive
income refers to revenues, expenses, gains and losses that generally accepted
accounting principles recognize as changes in value to an enterprise but are
excluded from net income. For the Company, comprehensive income includes net
income (loss) and changes in fair value of its available-for-sale investment
securities.
Recent Accounting Pronouncements -In June 2001, the FASB issued Statement No.
143, Accounting for Asset Retirement Obligations. This Statement addresses
financial accounting and reporting for obligations associated with the
retirement of tangible long-lived assets and the associated asset retirement
costs. This Statement requires that the fair value of a liability for an asset
retirement obligation be recognized in the period in which it is incurred if a
reasonable estimate of fair value can be made. The associated asset retirement
costs are capitalized as part of the carrying amount of the long-lived asset.
This Statement is effective for financial statements issued for fiscal years
beginning after June 15, 2002. The Company does not anticipate that the adoption
of Statement No. 143 will have a material impact on the financial condition or
operating results of the Company.
In April 2002, the FASB issued Statement No. 145, Rescission of FASB
Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and
Technical Corrections. This Statement rescinds FASB Statement No. 4,
Reporting Gains and Losses from Extinguishment of Debt, and an
amendment of that Statement, FASB Statement No. 64, Extinguishments of
Debt Made to Satisfy Sinking-Fund Requirements. This Statement also
rescinds FASB Statement No. 44, Accounting for Intangible Assets of
Motor Carriers. This Statement amends FASB Statement No. 13,
Accounting for Leases, to eliminate an inconsistency between the
required accounting for sale-leaseback transactions and the required
accounting for certain lease modifications that have economic effects
that are similar to sale-leaseback transactions. This Statement also
amends other existing authoritative pronouncements to make various
technical corrections, clarify meanings, or describe their
applicability under changed conditions. The provisions of this
Statement related to the rescission of Statement 4 shall be applied in
fiscal years beginning after May 15, 2002. The provisions of this
Statement related to Statement 13 shall be effective for transactions
occurring after May 15, 2002. All other provisions of this statement
shall be effective for financial statements issued on or after May 15,
2002. The Company does not anticipate that the adoption of Statement
No. 145 will have a material impact on the financial condition or
operating results of the Company.
In July 2002, the Financial Accounting Standards Board ("FASB") issued SFAS 146,
"Accounting for Costs Associated with Exit or Disposal Activities," which
addresses financial accounting and reporting for costs associated with exit or
disposal activities and supersedes Emerging Issues Task Force (EITF) Issue 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS
146 requires that a liability for a cost associated with an exit or disposal
activity be recognized when the liability is incurred. Under Issue 94-3, a
liability for an exit cost as defined in EITF 94-3 was recognized at the date of
an entity's commitment to an exit plan. SFAS 146 also establishes that the
liability should initially be measured and recorded at fair value. We will adopt
the provisions of SFAS 146 for exit or disposal activities that are initiated
after December 31, 2002. The Company does not anticipate that the adoption of
Statement No. 146 will have a material impact on the financial condition or
operating results of the Company.
12
In October 2002, the Financial Accounting Standards Board ("FASB")
issued SFAS 147, "Acquisitions of Certain Financial Institutions, an
amendment of FASB Statements No. 72 and 144 and FASB Interpretation No. 9".
This Statement addresses the financial accounting and reporting for the
acquisition of all or part of a financial institution, except for a transaction
between two or more mutual enterprises. This Statement removes acquisitions of
financial institutions, other than transactions between two or more mutual
enterprises, from the scope of FASB Statement No. 72, "Accounting for Certain
Acquisitions of Banking or Trust Institutions", and FASB Interpretation No. 9,
"Applying APB Opinions No. 16 and 17 When a Savings and Loan Association or a
Similar Institution Is Acquired in a Business Combination Accounted for by the
Purchase Method". This Statement also provides guidance on the accounting for
the impairment or disposal of acquired long-term customer-relationship
intangible assets (such as depositor- and borrower-relationship intangible
assets and credit cardholder intangible assets), including those acquired in
transactions between two or more mutual enterprises. We will adopt the
provisions of SFAS 147 for acquisitions for which the date of acquisition is on
or after October 1, 2002. The Company does not anticipate that the adoption of
Statement No. 147 will have a material impact on the financial condition or
operating results of the Company.
ITEM 2.
Management's Discussion and Analysis
Management's discussion and analysis is written to provide greater insight into
the results of operations and the financial condition of Farmers & Merchants
Bancorp and its subsidiaries. Throughout this discussion, "Company" refers to
Farmers & Merchants Bancorp and its subsidiaries as a consolidated entity and
"Bank" refers to Farmers & Merchants Bank of Central California. For a more
complete understanding of the Company and its operations, reference should be
made to the financial statements included in this report and in the Company's
2001 Annual Report on Form 10-K. Certain statements in this Report on Form 10-Q
constitute "forward-looking statements" and usually contain the words
"estimate," "project," "expect," "objective," "goal," or similar expressions and
include assumptions concerning the Company's operations, future results, and
prospects. These forward-looking statements are based upon current expectations
and are subject to risk and uncertainties. In connection with the "safe-harbor"
provisions of the private Securities Litigation Reform Act of 1995, the Company
provides the following cautionary statement identifying important factors which
could cause the actual results of events to differ materially from those set
forth in or implied by the forward-looking statements and related assumptions.
Such factors include the following: (i) the effect of changing regional and
national economic conditions; (ii) significant changes in interest rates and
prepayment speeds; (iii) credit risks of commercial, real estate, consumer, and
other lending activities; (iv) changes in federal and state Banking regulations
and; (v) other external developments which could materially impact the Company's
operational and financial performance. Readers are cautioned not to place undue
reliance on these forward-looking statements, which speak only as of the date
hereof. The Company undertakes no obligation to update any forward-looking
statements to reflect events or circumstances arising after the date on which
they are made.
13
Analysis of the Results of Operations
Overview
For the three and nine months ended September 30, 2002, Farmers & Merchants
Bancorp reported net income of $3,445,000 and $9,827,000 earnings per share of
$4.68 and $13.29, return on average assets of 1.45% and 1.39%. Return on average
shareholders' equity (net of accumulated other comprehensive income) was 13.86%
and 13.34% for the three and nine months ended September 30, 2002. For the three
and nine months ending September 30, 2001, net income totaled $3,162,000 and
9,363,000, earnings per share was $4.19 and $12.39, return on average assets was
1.37% and 1.39%. Return on average shareholders' equity (net of accumulated
other comprehensive income) was 13.32% for both the three and nine months ended
September 30, 2001.
The Company's improved earnings performance in 2002 was due to a combination of
change in asset mix, improvement in non-interest income, control of non-interest
expense and a reduction of the Company's effective tax rate.
The following is a summary of the financial results for the nine-month period
ending September 30, 2002 compared to September 30, 2001.
o Net income for the period totaled $9.8 million, up 4.9% over one year ago.
o Net interest income decreased 1.3% to $30.3 million from $30.7 million.
o The provision for loan losses totaled $1.0 million for the period compared to
$750 thousand one year ago.
o Non-interest income increased 28.4% to $7.9 million, from the $6.1 million
reported for 2001.
o Non-interest expense increased 4.4% to $21.6 million, from $20.7 million in
2001.
o Total assets increased 2.4% to $955.2 million.
o Gross loans increased 22.8% to $685.9 million, an increase of $127.3 million.
o Total deposits increased 2.6% to $801.2 million.
o Investment securities totaled $175.4 million compared to $283.2 million at
September 30, 2001.
o Total shareholders' equity increased $2.6 million to $103.9 million.
Net Interest Income
Net interest income is the amount by which the interest and fees on loans and
interest earning assets exceed the interest paid on interest bearing sources of
funds. For the purpose of analysis, the interest earned on tax-exempt
investments and municipal loans is adjusted to an amount comparable to interest
subject to normal income taxes. This adjustment is referred to as "taxable
equivalent" and is noted wherever applicable. Interest income and expense are
affected by changes in the volume and mix of average interest earning assets and
average interest bearing liabilities, as well as fluctuations in interest rates.
Therefore, increases or decreases in net interest income are analyzed as changes
in volume, changes in rate and changes in the mix of assets and liabilities.
14
Net interest income declined 1.3% to $30.3 million during the first nine months
of 2002, compared to $30.7 million at September 30, 2001. Net interest income
for the quarter ended September 30, 2002 and 2001 totaled $10.3 and $9.9
million, respectively. On a fully taxable equivalent basis, net interest income
decreased 1.4% and totaled $31.2 million at September 30, 2002, compared to
$31.6 million for the first nine months of 2001. Net interest income on a
taxable equivalent basis, expressed as a percentage of average total earning
assets, is referred to as the net interest margin, which represents the average
net effective yield on earning assets. . For the nine months ended September 30,
2002, the net interest margin was 4.8% compared to 4.9% in 2001. For the three
months ended September 30, 2002, the net interest margin was 4.8% compared to
4.6% for the same period in 2001.
Loans, the Company's highest earning asset, increased $127.4 million as of
September 30, 2002 compared to September 30, 2001. On an average balance basis,
loans increased by $130.2 million for the three months ended September 30, 2002
and $112.4 million for the nine months ended September 2002. Due to the decline
in interest rates during 2001, the yield on the loan portfolio decreased 164 and
214 basis points to 6.5% and 6.6% for the three and nine months ending September
30, 2002 compared to 8.12% and 8.79% for the three and nine months ending
September 30, 2001. This decrease in yield was partially offset by the growth in
loan balances, which minimized the decrease in interest revenue from loans to
$2.7 million for the first nine months of 2002.
The investment portfolio is the other main component of the Company's earning
assets. The Company's investment policy is conservative. The Company primarily
invests in mortgage-backed securities, U.S. Treasuries, U.S. Government
Agencies, and high-grade municipals. Since the risk factor for these types of
investments is significantly lower than that of loans, the yield earned on
investments is less than that of loans.
Average investment securities decreased $82.2 million compared to the average
balance at September 30, 2001. As securities matured, the proceeds were used to
fund loan growth. The decrease in the average balance of investment securities
was followed with a corresponding decrease in interest income of $4.3 million
for the nine months ending September 30, 2002. The average yield, on a taxable
equivalent basis, in the investment portfolio was 6.4% in 2002 compared to 6.5%
in 2001. Net interest income on the Average Balance Sheet is shown on a taxable
equivalent basis, which is higher than net interest income on the Consolidated
Statements of Income because of adjustments that relate to income on certain
securities that are exempt from federal income taxes.
Average interest-bearing deposits increased $20.5 million or 3.4% from a year
ago. As a result of the decline in interest rates, interest expense on
interest-bearing deposits decreased 46.5%. Overall, the average interest cost on
interest bearing deposits was 1.9% for the nine-month period ended September 30,
2002 and 3.7% at September 30, 2001.
The Company's earning assets and rate sensitive liabilities are subject to
repricing at different times, which exposes the Company to income fluctuations
when interest rates change. In order to minimize income fluctuations, the
Company attempts to match asset and liability maturities. However, some maturity
mismatch is inherent in the asset and liability mix.
15
Allowance for Loan Losses
As a financial institution that assumes lending and credit risks as a principal
element of its business, the Company anticipates that credit losses will be
experienced in the normal course of business. The allowance for loan losses is
established to absorb losses inherent in the portfolio. The allowance for loan
losses is maintained at a level considered by management to be adequate to
provide for risks inherent in the loan portfolio. In determining the adequacy of
the allowance for loan losses, management takes into consideration examinations
by the Company's supervisory authorities, results of internal credit reviews,
financial condition of borrowers, loan concentrations, prior loan loss
experience, and general economic conditions. The allowance is based on estimates
and ultimate losses may vary from the current estimates. Management reviews
these estimates periodically and, when adjustments are necessary, they are
reported in the period in which they become known.
The Company's written lending policies, along with applicable laws and
regulations governing the extension of credit, require risk analysis as well as
ongoing portfolio and credit management through loan product diversification,
lending limits, ongoing credit reviews and approval policies prior to funding of
any loan. The Company manages and controls credit risk through diversification,
dollar limits on loans to one borrower and by primarily restricting loans made
to its principal market area. Loans that are performing but have shown some
signs of weakness are subjected to more stringent reporting. Fixed-rate real
estate loans are comprised primarily of loans with maturities of less than five
years. Generally, long-term residential loans are originated by the Company and
sold on the secondary market.
The appropriate allowance amount is based upon growth in the loan portfolio,
management's evaluation of the credit quality of the loan portfolio, the
prevailing economic climate, and its effect on borrowers' ability to repay loans
in accordance with the terms of the notes and current loan losses. After
reviewing all factors, management concluded that the current allowance for loan
losses was adequate.
As of September 30, 2002, the allowance for loan losses was $13.1million, which
represents 1.9% of the total loan balances. For the period ended September 30,
2001, the allowance was $13.0 million and 2.3% of total loans. The table below
illustrates the change in the allowance for the first nine months of 2002 and
2001.
Allowance for Loan Losses (in thousands)
- --------------------------
Balance, December 31, 2001 $ 12,709
Provision Charged to Expense 1,000
Recoveries of Loans Previously Charged Off 490
Loans Charged Off (1,081)
=============================================================
Balance, September 30, 2002 13,118
=============================================================
Balance, December 31, 2000 $ 11,876
Provision Charged to Expense 750
Recoveries of Loans Previously Charged Off 657
Loans Charged Off (254)
=============================================================
Balance, September 30, 2001 $ 13,029
=============================================================
16
Non-Interest Income
Overall, non-interest income increased $1.7 million or 28.4% for the nine months
ending September 30, 2002 compared to the same period of 2001. For the third
quarter of 2002, non-interest income increased 17.0% over the same quarter of
last year. Service charges on deposits increased $453 thousand for the nine
months ended September 30, 2002, due to additional services offered and pricing
considerations. $16.7 million in investment securities, which were close to
their maturity date, were sold to aid in funding loan growth. This sale resulted
in a gain of $263 thousand during second quarter of 2002. Other non-interest
income grew $1.1 million through the third quarter of 2002. The increase was the
result of the increase in the cash surrender value of life insurance contracts,
which is recognized as other non-interest income.
Non-Interest Expense
Salaries and Employee Benefits increased $166 thousand or 1.3% from the prior
year due to merit increases and additional staffing requirements. Occupancy
expense increased less than one percent from the prior year. For the quarter
ended September 30, 2002, occupancy expense decreased $16 thousand from the
quarter ended September 30, 2001. Equipment expense increased $235 thousand or
16.1% from the prior year. This increase was due to the purchase and
installation of a new voice and data system during first quarter of 2002. Also,
software and hardware maintenance increased in 2002 compared to 2001 due to the
conversion to a new core operating system during second quarter of 2001. Other
operating expense increased $505 thousand or 10.1% from September 30, 2001, due
to an increase in outside professional fees and an increase in marketing
expenditures promoting various loan products.
Overall, non-interest expense increased $912 thousand or 4.4% over the third
quarter of 2001. It is anticipated that the future growth rate in other
operating expense will remain modest and comparable to the growth in assets.
Income Taxes
The provision for income taxes decreased 1.4% to $2.0 million for the third
quarter of 2002, and 4.5% to $5.7 million for the first nine months of 2002.
This was due to the purchase of insurance contracts in which the increase in the
cash surrender value, which is recorded in non-interest income, is exempt from
federal and state income taxes. For the nine months ended September 30, 2001,
the provision totaled $5.9 million. Additionally, the Company's effective tax
rate decreased for the first nine months of 2002 and was 36.6% compared to 38.8%
for the same period in 2001.
Balance Sheet Analysis
Investment Securities
The Financial Accounting Standards Board statement, Accounting for Certain
Investments in Debt and Equity Securities, requires the Company to classify its
investments as held-to-maturity, trading or available-for-sale. Securities are
classified as held-to-maturity and accounted for at amortized cost when the
Company has the positive intent and ability to hold the securities to maturity.
Trading securities are securities acquired for short-term appreciation and are
carried at fair value, with unrealized gains and losses recorded in non-interest
income. Securities classified as available-for-sale include securities, which
may be sold to effectively manage interest rate risk exposure, prepayment risk,
satisfy liquidity demand and other factors. These securities are reported at
fair value with aggregate, unrealized gains or losses excluded from income and
included as a separate component of shareholders' equity, net of related income
taxes.
17
The investment portfolio provides the Company with an income alternative to
loans. As of September 30, 2002 the investment portfolio represented 18.4% of
the Company's total assets. Total investment securities decreased $107.9 million
from a year ago and now total $175.4 million. This decrease was used to fund the
Bank's strong loan growth. Not included in the investment portfolio are
overnight investments in Federal Funds Sold. For the nine months ended September
30, 2002, average Federal Funds Sold was $30.2 million compared to $46.3 in
2001.
Loans
The Company's loan portfolio at September 30, 2002 increased $127.4 million from
September 30, 2001. The increase is the result of an aggressive calling program
on high quality loan prospects. Additionally, on an average balance basis loans
have increased $112.4 million or 21.9%. Management believes that loans will
continue to grow at a moderate rate through fourth quarter, 2002. The table
following sets forth the distribution of the loan portfolio by type as of the
dates indicated.
Loan Portfolio As Of:
(in thousands) September 30, 2002 Dec. 31, 2001 September 30, 2001
- ---------------------------------------- ------------------------- ---------------------- -------------------------
Real Estate Construction $ 54,255 $ 49,692 $ 40,588
Real Estate - Other 360,097 304,451 284,649
Commercial 251,970 227,909 210,560
Consumer 19,619 21,133 22,787
- ---------------------------------------- ------------------------- ---------------------- -------------------------
Gross Loans 685,941 603,185 558,584
Less:
Unearned Income 1,554 1,016 586
Allowance for Loan Losses 13,118 12,709 13,029
- ---------------------------------------- ------------------------- ---------------------- -------------------------
Net Loans $ 671,269 $ 589,460 $ 544,969
======================================== ========================= ====================== =========================
In the ordinary course of business, the Company enters into commitments to
extend credit to its customers. These commitments are not reflected in the
accompanying consolidated financial statements. As of September 30, 2002, the
Company had entered into commitments with certain customers amounting to $238.0
million compared to $226.4 million at December 31, 2001. Letters of credit at
September 30, 2002, and December 31, 2001, were $13.8 million and $3.6 million,
respectively.
Non-Performing Assets
As set forth in the table below, non-performing loans as of September 30, 2002,
were $3.7 million compared to $1.5 million at September 30, 2001. Accrued
interest reversed from income on loans placed on a non-accrual status totaled
$285 thousand at September 30, 2002 compared to $36 thousand at September 30,
2001. The Company reported no other real estate owned for both September 30,
2002 and September 30, 2001.
Non-Performing Assets
(dollar amounts in thousands) Sept. 30, 2002 Dec. 31, 2001 Sept. 30, 2001
- ---------------------------------------- ----------------------- ------------------------ -----------------------
Nonperforming Loans $3,721 $2,409 $1,537
Other Real Estate Owned 0 0 0
======================================== ======================= ======================== =======================
Total $3,721 $2,409 $1,537
======================================== ======================= ======================== =======================
Non-Performing Assets
as a % of Total Loans 0.5% 0.4% 0.3%
Allowance for Loan Losses as a % of
Non-Performing Loans 352.5% 527.6% 847.7%
18
Except for non-performing loans shown in the table above, the Bank's management
is not aware of any loans as of September 30, 2002 for which known credit
problems of the borrower would cause serious doubts as to the ability of such
borrowers to comply with their present loan repayment terms, or any known events
that would result in the loan being designated as non-performing at some future
date. The Bank's management cannot, however, predict the extent to which the
deterioration in general economic conditions, real estate values, increase in
general rates of interest, change in the financial conditions or business of a
borrower may adversely affect a borrower's ability to pay.
Deposits
The primary source of funds to support earning assets (loans and investments) is
the generation of deposits from the Company's customer base. The ability to grow
the customer base and subsequently deposits is a significant element in the
performance of the Company.
At September 30, 2002, deposits totaled $801.2 million. This represents an
increase of 2.6% or $20.7 million from September 30, 2001. The increase was
focused in demand, interest bearing transaction (IBT) and savings accounts,
which increased $18.8 million, $2.6 million and $36.7 million, respectively. The
Bank's calling efforts for prospective customers includes acquiring both loan
and deposit relationships which results in new demand, IBT and savings accounts.
While demand, IBT and savings accounts have increased; time deposit balances
have decreased $37.5 million or 10.9%. Rates are low and as existing customers'
CD's mature those customers are opting to instead invest in short-term deposits.
It is expected that this trend will continue through fourth quarter of 2002.
Capital
Much attention has been directed at the capital adequacy of the financial
institution industry. The Company relies on capital generated through the
retention of earnings to satisfy its capital requirements. The Company engages
in an ongoing assessment of its capital needs in order to support business
growth and to insure depositor protection. Shareholders' Equity totaled $103.9
million at September 30, 2002 and $101.3 million at September 30, 2001, which
represents an increase of $2.6 million or 2.6%.
The Board of Governors of the Federal Reserve System, and the Federal Deposit
Insurance Corporation have adopted risk-based capital guidelines. The guidelines
are designed to make capital requirements more sensitive to differences in risk
related assets among Banking organizations, to take into account off-balance
sheet exposures and to aid in making the definition of Bank capital uniform.
Company assets and off-balance sheet items are categorized by risk. The results
of these regulations are that assets with a higher degree of risk require a
larger amount of capital; assets, such as cash, with a low degree of risk have
little or no capital requirements. Under the guidelines the Company is currently
required to maintain regulatory risk based capital equal to at least 8.0%. As of
September 30, 2002 the Company meets all capital adequacy requirements to which
it is subject. The following table illustrates the relationship between
regulatory capital requirements and the Company and Bank's capital position.
To Be Well
Capitalized Under
Regulatory Capital Prompt Corrective
(in thousands) Actual Requirements Action Provisions
- ------------------------------------------------------------------------------------------------------------------
The Company: Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------
As of September 30, 2002
Total Capital to Risk Weighted Assets $112,622 12.76% $70,629 8.0% N/A N/A
Tier I Capital to Risk Weighted Assets $101,561 11.50% $35,315 4.0% N/A N/A
Tier I Capital to Average Assets $101,561 10.70% $37,979 4.0% N/A N/A
19
To Be Well
Capitalized Under
Regulatory Capital Prompt Corrective
(in thousands) Actual Requirements Action Provisions
- ------------------------------------------------------------------------------------------------------------------
The Bank: Amount Ratio Amount Ratio Amount Ratio
- ------------------------------------------------------------------------------------------------------------------
As of September 30, 2002
Total Capital to Risk Weighted Assets $108,205 12.31% $70,348 8.0% $87,935 10.0%
Tier I Capital to Risk Weighted Assets $97,187 11.05% $35,174 4.0% $52,761 6.0%
Tier I Capital to Average Assets $97,187 10.28% $37,806 4.0% $47,257 5.0%
Risk Management
The Company has adopted a Risk Management Plan to ensure the proper control and
management of all risk factors inherent in the operation of the Company and the
Bank. Specifically, credit risk, interest rate risk, liquidity risk, compliance
risk, strategic risk, reputation risk and price risk can all affect the market
risk of the Company. These specific risk factors are not mutually exclusive. It
is recognized that any product or service offered by the Company may expose the
Company and Bank to one or more of these risk factors.
Credit Risk
Credit risk is the risk to earnings or capital arising from an obligor's failure
to meet the terms of any contract or otherwise fail to perform as agreed. Credit
risk is found in all activities where success depends on counterparty, issuer,
or borrower performance.
Central to the Company's credit risk management is a proven loan risk rating
system. Limitations on industry concentration, aggregate customer borrowings and
geographic boundaries also reduce loan credit risk. Credit risk in the
investment portfolio is minimized through clearly defined limits in the Bank's
policy statements. Senior Management, Directors Committees, and the Board of
Directors are provided with timely and accurate information to appropriately
identify, measure, control and monitor the credit risk of the Company and the
Bank.
The allowance for loan losses is based on estimates of probable losses inherent
in the loan portfolio. The amount actually incurred with respect to these losses
can vary significantly from the estimated amounts. The Company's methodology
includes several features which are intended to reduce the difference between
estimated and actual losses.
Implicit in lending activities is the risk that losses will and do occur and
that the amount of such losses will vary over time. Consequently, the Company
maintains an allowance for loan losses by charging a provision for loan losses
to earnings. Loans determined to be losses are charged against the allowance for
loan losses. The Company's allowance for loan losses is maintained at a level
considered by management to be adequate to provide for estimated credit losses
inherent in the portfolio.
The Company's methodology for assessing the appropriateness of the allowance
consists of several key elements, which include the formula allowance and
specific allowances for identified problem loans and portfolio segments.
Specific allowances are established in cases where management has identified
conditions or circumstances related to credit that management believes indicate
the possibility that a loss may be incurred in excess of the amount determined
by the application of the formula reserve. Management performs a detailed
analysis of these loans, including, but not limited to appraisals of the
collateral, conditions of the marketplace for liquidating the collateral and
assessment of the guarantors. Management then determines the loss potential and
allocates a portion of the allowance for losses for each of these credits.
20
Management believes that the allowance for loan losses at September 30, 2002 was
adequate to provide for recognized, unidentified and estimated inherent losses
in the portfolio. No assurances can be given that future events may not result
in increases in delinquencies, non-performing loans or net loan chargeoffs that
would increase the provision for loan losses and thereby adversely affect the
results of operations.
Asset / Liability Management - Interest Rate Risk
The mismatch between maturities of interest sensitive assets and liabilities
results in uncertainty in the Company's earnings and economic value and is
referred to as interest rate risk. Farmers & Merchants Bancorp's primary
objective in managing interest rate risk is to minimize the potential for
significant loss as a result of changes in interest rates.
The Company measures interest rate risk in terms of potential impact on both its
economic value and earnings. The methods for governing the amount of interest
rate risk include: analysis of asset and liability mismatches (GAP analysis),
the utilization of a simulation model and limits on maturities of investment,
loan and deposit products to relatively short periods which reduces the market
volatility of those instruments.
The gap analysis measures, at specific time intervals, the divergence between
earning assets and interest bearing liabilities for which repricing
opportunities will occur. A positive difference, or gap, indicates that earning
assets will reprice faster than interest-bearing liabilities. This will
generally produce a greater net interest margin during periods of rising
interest rates and a lower net interest margin during periods of declining
interest rates. Conversely, a negative gap will generally produce a lower net
interest margin during periods of rising interest rates and a greater net
interest margin during periods of decreasing interest rates.
The interest rates paid on deposit accounts do not always move in unison with
the rates charged on loans. In addition, the magnitude of changes in the rates
charged on loans is not always proportionate to the magnitude of changes in the
rate paid for deposits. Consequently, changes in interest rates do not
necessarily result in an increase or decrease in the net interest margin solely
as a result of the differences between repricing opportunities of earning assets
or interest bearing liabilities.
The Company also utilizes the results of a dynamic simulation model to quantify
the estimated exposure of net interest income to sustained interest rate
changes. The sensitivity of the Company's net interest income is measured over a
rolling one-year horizon. The simulation model estimates the impact of changing
interest rates on interest income from all interest earning assets and the
interest expense paid on all interest bearing liabilities reflected on the
Company's balance sheet. This sensitivity analysis is compared to policy limits,
which specify a maximum tolerance level for net interest income exposure over a
one-year horizon assuming no balance sheet growth, given both a 200 basis point
upward and downward shift in interest rates. A parallel and pro rata shift in
rates over a 12-month period is assumed. Results that exceed policy limits, if
any, are analyzed for risk tolerance and reported to the Board with appropriate
recommendations. At September 30, 2002, the Company's estimated net interest
income sensitivity to changes in interest rates, as a percent of net interest
income was an increase in net interest income of 4.7% if rates increase by 200
basis points and a decrease in net interest income of 2.2% if rates decline 100
basis points.
21
The estimated sensitivity does not necessarily represent a Company forecast and
the results may not be indicative of actual changes to the Company's net
interest income. These estimates are based upon a number of assumptions
including: the nature and timing of interest rate levels including yield curve
shape, prepayments on loans and securities, pricing strategies on loans and
deposits, replacement of asset and liability cashflows, and other assumptions.
While the assumptions used are based on current economic and local market
conditions, there is no assurance as to the predictive nature of these
conditions including how customer preferences or competitor influences might
change.
Liquidity
Liquidity risk is the risk to earnings or capital resulting from the Bank's
inability to meet its obligations when they come due without incurring
unacceptable losses. It includes the ability to manage unplanned decreases or
changes in funding sources and to recognize or address changes in market
conditions that affect the Bank's ability to liquidate assets or acquire funds
quickly and with minimum loss of value. The Company endeavors to maintain a cash
flow adequate to fund operations, handle fluctuations in deposit levels, respond
to the credit needs of borrowers and to take advantage of investment
opportunities as they arise. The principal sources of liquidity include interest
and principal payments on loans and investments, proceeds from the maturity or
sale of investments, and growth in deposits.
In general, liquidity risk is managed daily by controlling the level of Fed
Funds and the use of funds provided by the cash flow from the investment
portfolio. The Company maintains overnight investments in Fed Funds as a reserve
for temporary liquidity needs. During the first nine months of 2002, Federal
Funds averaged $30.2 million. In addition, the Company maintains Federal Fund
credit lines of $136 million with major correspondent banks subject to the
customary terms and conditions for such arrangements.
At September 30, 2002, the Company had available liquid assets, which included
cash and unpledged investment securities of approximately $112.5 million, which
represents 11.8% of total assets. For short term liquidity needs the Bank has
$50 million in unused fed funds lines with other financial institutions. On a
long term basis the Bank relies on deposit growth and has available funding
sources of an additional $243 million through the Federal Home loan Bank and
approved brokered deposit sources.
Average Balance Sheets
The tables on the following pages reflect the Company's average balance sheets
and volume and rate analysis for the three-month and nine-month periods ending
September 30, 2002 and 2001.
The average yields on earning assets and average rates paid on interest-bearing
liabilities have been computed on an annualized basis for purposes of
comparability with full year data. Average balance amounts for assets and
liabilities are the computed average of daily balances.
The volume and rate analysis of net interest revenue summarizes the changes in
average asset and liability balances and interest earned and paid resulting from
changes in average asset and liability balances (volume) and changes in average
interest rates and the total net change in interest income and expenses. The
changes in interest due to both rate and volume have been allocated to volume
and rate changes in proportion to the relationship of the absolute dollar amount
of the change in each.
22
Farmers & Merchants Bancorp
Quarterly Average Balances and Interest Rates
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Three Months Ended September 30, Three Months Ended September 30,
2002 2001
Assets Balance Interest Rate Balance Interest Rate
- ----------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ 24,857 $ 55 0.88% $ 52,125 $ 458 3.49%
Investment Securities Available-for-Sale
U.S. Treasuries 0 0 0.00% 0 0 0.00%
U.S. Agencies 0 0 0.00% 5,078 72 5.63%
Municipals - Taxable 1,469 22 6.07% 1,850 30 6.43%
Municipals - Non-Taxable 21,989 368 6.79% 22,161 369 6.61%
Mortgage Backed Securities 122,101 1,794 5.96% 215,810 3,410 6.27%
Other 8,306 149 7.18% 6,099 93 6.05%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Available-for-Sale 153,865 2,333 6.14% 250,998 3,974 6.28%
- ----------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Treasuries 0 0 0.00% 0 0 0.00%
U.S. Agencies 0 0 0.00% 0 0 0.00%
Municipals - Taxable 0 0 0.00% 1,012 21 8.23%
Municipals - Non-Taxable 28,435 521 7.44% 31,643 581 7.29%
Mortgage Backed Securities 0 0 0.00% 0 0 0.00%
Other 530 8 6.12% 635 16 10.00%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Held-to-Maturity 28,965 529 7.41% 33,290 618 7.37%
- ----------------------------------------------------------------------------------------------------------------------------------
Loans
Real Estate 400,300 6,834 6.77% 314,255 6,590 8.32%
Commercial 251,125 3,687 5.82% 203,390 3,876 7.56%
Installment 15,155 339 8.87% 18,973 491 10.27%
Credit Card 3,306 77 9.24% 3,358 95 11.22%
Municipal 1,205 17 5.60% 887 13 5.81%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Loans 671,091 10,954 6.48% 540,863 11,065 8.12%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 878,778 $13,871 6.26% 877,276 $16,115 7.29%
========================= =========================
Unrealized Gain/(Loss) on Securities Available-for-Sale 4,597 4,210
Allowance for Loan Losses (13,257) (12,987)
Cash and Due From Banks 28,438 29,309
All Other Assets 52,400 24,598
- ------------------------------------------------------------------- -------------
Total Assets $950,956 $922,406
=================================================================== =============
Liabilities & Shareholders' Equity
Interest Bearing Deposits
Interest Bearing DDA $85,062 $ 61 0.28% $78,712 $ 159 0.80%
Savings 223,153 422 0.75% 186,783 957 2.03%
Time Deposits 311,618 2,173 2.77% 346,865 4,165 4.76%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 619,833 2,656 1.70% 612,360 5,281 3.42%
Other Borrowed Funds 40,979 562 5.44% 41,012 570 5.51%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 660,812 $3,218 1.93% 653,372 $5,851 3.55%
========================= =========================
Demand Deposits (Non-Interest Bearing) 179,196 161,383
All Other Liabilities 8,877 10,191
- ------------------------------------------------------------------- -------------
Total Liabilities 848,885 824,946
Shareholders' Equity 102,071 97,460
- ------------------------------------------------------------------- -------------
Total Liabilities & Shareholders' Equity $950,956 $922,406
=================================================================== =============
Net Interest Margin 4.81% 4.64%
==================================================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable
equivalent basis using the applicable Federal and State income tax rates for the
period. Recognized loan Fees are included in interest income for loans. Unearned
discount is included for rate calculation purposes. Nonaccrual loans have been
included in the average balances. Yields on securities available-for-sale are
based on historical cost.
23
Farmers & Merchants Bancorp
Year-to-Date Average Balances and Interest Rates
(Interest and Rates on a Taxable Equivalent Basis)
(in thousands)
Nine Months Ended September 30, Nine Months Ended September 30,
2002 2001
Assets Balance Interest Rate Balance Interest Rate
- ----------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ 30,203 $ 385 1.70% $ 46,302 $ 1,560 4.49%
Investment Securities Available-for-Sale
U.S. Treasuries 0 0 0.00% 1,365 55 5.37%
U.S. Agencies 3,363 133 5.35% 5,655 243 5.72%
Municipals - Taxable 1,567 73 6.30% 1,942 91 6.24%
Municipals - Non-Taxable 21,899 1,097 6.77% 21,903 1,056 6.42%
Mortgage Backed Securities 150,659 6,874 6.17% 225,320 10,778 6.37%
Other 8,721 459 7.03% 5,441 279 6.83%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Available-for-Sale 186,209 8,636 6.27% 261,626 12,502 6.37%
- ----------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held-to-Maturity
U.S. Treasuries 0 0 0.00% 0 0 0.00%
U.S. Agencies 0 0 0.00% 491 22 5.97%
Municipals - Taxable 0 0 0.00% 2,291 114 6.63%
Municipals - Non-Taxable 29,231 1,610 7.45% 33,088 1,852 7.45%
Mortgage Backed Securities 0 0 0.00% 0 0 0.00%
Other 538 25 6.28% 651 49 10.03%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Held-to-Maturity 29,769 1,635 7.43% 36,521 2,037 7.43%
- ----------------------------------------------------------------------------------------------------------------------------------
Loans
Real Estate 376,570 19,808 7.03% 301,020 20,322 8.99%
Commercial 228,337 9,936 5.82% 187,168 11,627 8.28%
Consumer 15,666 1,053 8.99% 19,908 1,515 10.14%
Credit Card 3,304 235 9.51% 3,428 280 10.88%
Municipal 987 50 6.77% 894 57 8.49%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Loans 624,864 31,082 6.65% 512,418 33,801 8.79%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 871,045 $41,738 6.41% 856,867 $49,900 7.76%
========================= =========================
Unrealized Gain/(Loss) on Securities Available-for-Sale 4,868 2,940
Allowance for Loan Losses (13,115) (12,469)
Cash and Due From Banks 28,443 27,912
All Other Assets 48,926 25,518
- ------------------------------------------------------------------- -------------
Total Assets $940,167 $900,768
=================================================================== =============
Liabilities & Shareholders' Equity
Interest Bearing Deposits
Interest Bearing DDA $87,252 $ 225 0.34% $75,376 $ 507 0.90%
Savings 216,258 1,562 0.97% 181,402 2,827 2.08%
Time Deposits 311,897 7,070 3.03% 338,108 13,237 5.22%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 615,407 8,857 1.92% 594,886 16,571 3.71%
Other Borrowed Funds 40,988 1,668 5.44% 41,021 1,680 5.46%
- ----------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 656,395 $10,525 2.14% 635,907 $18,251 3.82%
========================= =========================
Demand Deposits (Non-Interest Bearing) 174,231 159,882
All Other Liabilities 8,503 9,513
- ------------------------------------------------------------------- -------------
Total Liabilities 839,129 805,302
Shareholders' Equity 101,038 95,466
- ------------------------------------------------------------------- -------------
Total Liabilities & Shareholders' Equity $940,167 $900,768
=================================================================== =============
Net Interest Margin 4.79% 4.92%
==================================================================================================================================
Notes: Yields on municipal securities have been calculated on a fully taxable
equivalent basis using the applicable Federal and State income tax rates for the
period. Recognized loan Fees are included in interest income for loans. Unearned
discount is included for rate calculation purposes. Nonaccrual loans have been
included in the average balances. Yields on securities available-for-sale are
based on historical cost.
24
Farmers & Merchants Bancorp
Volume and Rate Analysis of Net Interest Revenue
(Rates on a Taxable Equivalent Basis)
(in thousands) Three Months Ended Nine Months Ended
Sept. 30, 2002 vs. Sept. 30, 2001 Sept. 30, 2002 vs. Sept. 30, 2001
Interest Earning Assets Volume Rate Net Chg. Volume Rate Net Chg.
- ---------------------------------------------------------------------------------------------------------------------------------
Federal Funds Sold $ (166) $ (237) $ (403) $ (423) $ (752) $ (1,175)
Investment Securities Available for Sale
U.S. Treasuries 0 0 0 (27) (27) (54)
U.S. Agencies (36) (37) (73) (94) (15) (109)
Municipals - Taxable (7) (2) (9) (19) 1 (18)
Municipals - Non-Taxable (18) 18 0 0 41 41
Mortgage Backed Securities (1,450) (165) (1,615) (3,560) (344) (3,904)
Other 31 25 56 167 12 179
- ---------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Available for Sale (1,480) (161) (1,641) (3,533) (332) (3,865)
- ---------------------------------------------------------------------------------------------------------------------------------
Investment Securities Held to Maturity
U.S. Treasuries 0 0 0 0 0 0
U.S. Agencies 0 0 0 (11) (11) (22)
Municipals - Taxable (10) (10) (20) (57) (57) (114)
Municipals - Non-Taxable (128) 68 (60) (241) (2) (243)
Mortgage Backed Securities 0 0 0 0 0 0
Other (2) (6) (8) (7) (16) (23)
- ---------------------------------------------------------------------------------------------------------------------------------
Total Investment Securities Held to Maturity (140) 52 (88) (316) (86) (402)
- ---------------------------------------------------------------------------------------------------------------------------------
Loans:
Real Estate 5,935 (5,691) 244 6,041 (6,556) (515)
Commercial 3,474 (3,663) (189) 3,195 (4,886) (1,691)
Installment (91) (61) (152) (302) (160) (462)
Credit Card (2) (17) (19) (10) (35) (45)
Other 7 (3) 4 8 (15) (7)
- ---------------------------------------------------------------------------------------------------------------------------------
Total Loans 9,323 (9,435) (112) 8,932 (11,652) (2,720)
- ---------------------------------------------------------------------------------------------------------------------------------
Total Earning Assets 7,537 (9,781) (2,244) 4,660 (12,822) (8,162)
- ---------------------------------------------------------------------------------------------------------------------------------
Interest Bearing Liabilities
Interest Bearing Deposits:
Transaction 80 (178) (98) 112 (395) (283)
Savings 1,003 (1,538) (535) 731 (1,995) (1,264)
Time Deposits (388) (1,603) (1,991) (963) (5,204) (6,167)
- ---------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Deposits 695 (3,319) (2,624) (120) (7,594) (7,714)
Other Borrowed Funds (1) (8) (9) (2) (10) (12)
- ---------------------------------------------------------------------------------------------------------------------------------
Total Interest Bearing Liabilities 694 (3,327) (2,633) (122) (7,604) (7,726)
- ---------------------------------------------------------------------------------------------------------------------------------
Total Change $ 6,843 $ (6,454) $ 389 $ 4,782 $ (5,218) $ (436)
=================================================================================================================================
Notes: Rate/volume variance is allocated based on the percentage relationship of
changes in volume and changes in rate to the total "net change." The above
figures have been rounded to the nearest whole number.
25
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
None
ITEM 2. Changes in Securities
None
ITEM 3. Defaults Upon Senior Securities
Not applicable
ITEM 4. Submission of Matters to a Vote of Security Holders
None
ITEM 5. Other Information
None
ITEM 6(a). Exhibits
See Exhibit Index on Page 28
ITEM 6(b). Reports on Form 8-K
None
26
SIGNATURES
Pursuant to the requirement 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.
FARMERS & MERCHANTS BANCORP
Date: November 7, 2002 /s/Kent A. Steinwert
------------------------
Kent A. Steinwert
President and
Chief Executive Officer
(Principal Executive Officer)
Date: November 7, 2002 /s/John R. Olson
------------------------
John R. Olson
Executive Vice President and
Chief Financial Officer
(Principal Accounting Officer)
27
Index to Exhibits
Exhibit No. Description
2 Plan of Reorganization as filed on Form 8-K dated April 30, 1999, are
incorporated herein by reference.
3(i) Amended and Restated Certificate of Incorporation of Farmers &
Merchants Bancorp, filed as Exhibit 3(i) to Registrant's 8-K dated
April 30, 1999, is incorporated herein by reference.
3(ii)By-Laws of Farmers & Merchants Bancorp, filed as Exhibit 3(i) to
Registrant's 8-K dated April 30, 1999, is incorporated herein by
reference.
10.1 Employment Agreement dated July 8, 1997, between Farmers & Merchants
Bank of Central California and Kent A. Steinwert, filed as Exhibit
10.1 to Registrant's 8-K dated April 30, 1999, is incorporated herein
by reference.
10.2 Employment Agreement dated July 8, 1997, between Farmers & Merchants
Bank of Central California and Richard S. Erichson, filed as Exhibit
10.2 to Registrant's 8-K dated April 30, 1999, is incorporated herein
by reference.
10.3 Deferred Bonus Plan of Farmers & Merchants Bank of Central California
adopted as of March 2, 1999, filed as Exhibit 10.3 to Registrant's 8-K
dated April 30, 1999, is incorporated herein by reference.
10.4 Amended and Restated Deferred Bonus Plan of Farmers & Merchants Bank
of Central California, executed May 11, 1999, filed as Exhibit 10.4 to
Registrant's 8-K dated April 30, 1999, is incorporated herein by
reference.
99.1 Chief Executive Officer Certification pursuant to 10 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
99.2 Chief Financial Officer Certification pursuant to 10 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
28