U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

Commission file number: 000-31593

 

BUSINESS BANCORP

(Exact name of registrant as specified in its charter)

 

 

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 ý  No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No ý

 

Outstanding shares of Common Stock, no par value, as of July 31, 2003: 4,021,403

 

 

BUSINESS BANCORP

 

INDEX

 

PART I.  FINANCIAL INFORMATION
Item 1. Financial Statements
	Consolidated Balance Sheets as of June 30, 2003 and December 31, 2002
	Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2003 and 2002
	Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2003 and 2002
	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2003 and 2002
	Notes to Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II.  OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Changes in Securities and Use of Proceeds
Item 3. Defaults Upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits and Reports on Form 8-K
Signatures
Exhibit Index

 

2

 

PART I - FINANCIAL INFORMATION

 

Item 1. Consolidated Financial Statements

 

BUSINESS BANCORP AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

		June 30, 2003			December 31, 2002
		(Unaudited)
		(Dollars in thousands )
ASSETS
Cash and cash equivalents		$	33,083		$	32,531
Investment securities:
Available for sale, at fair value		191,157			179,180
Other securities		3,267			2,641
Total investment securities		194,424			181,821
Loans, net of deferred fees		394,794			378,100
Allowance for loan losses		(5,566		)	(5,442		)
Total loans, net		389,228			372,658
Property, premises and equipment, net		12,669			12,361
Goodwill		20,121			20,121
Other intangible assets		1,838			1,790
Interest receivable and other assets		12,304			9,650
Total assets		$	663,667		$	630,932
LIABILITIES AND SHAREHOLDERS’ EQUITY
Deposits:
Demand, noninterest-bearing		$	192,767		$	184,728
MMDA, NOW and savings		265,301			244,364
Time certificates, $100,000 and over		60,260			64,510
Other time certificates		34,620			37,237
Total deposits		552,948			530,839
Borrowings		33,725			23,625
Company obligated mandatorily redeemable cumulative trust preferred securities of subsidiary trusts holding solely junior subordinated debentures		13,446			13,462
Accrued interest payable and other liabilities		3,822			4,560
Total liabilities		603,941			572,486
Commitments and contingencies
SHAREHOLDERS’ EQUITY
Serial preferred stock, no par value: 20,000,000 shares authorized; none issued
Common stock, no par value: 20,000,000 shares authorized; 4,021,403 and 4,142,144 shares issued and outstanding at June 30, 2003 and December 31, 2002, respectively		39,794			36,529
Accumulated other comprehensive income		3,041			2,430
Retained earnings		16,891			19,487
Total shareholders’ equity		59,726			58,446
Total liabilities and shareholders’ equity		$	663,667		$	630,932

 

See notes to consolidated financial statements

 

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BUSINESS BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
Dollars in thousands, except per share amounts		2003			2002			2003			2002
		(Unaudited)						(Unaudited)
INTEREST INCOME
Interest and fees on loans		$	7,558		$	7,741		$	14,886		$	15,421
Interest on investment securities:
Taxable		965			1,645			2,113			3,233
Tax-exempt		335			272			666			543
Other interest income		3			9			4			19
Total interest income		8,861			9,667			17,669			19,216
INTEREST EXPENSE
Interest on deposits		983			1,502			2,021			3,127
Interest on other borrowings		135			160			274			401
Interest on trust preferred securities		342			342			680			680
Total interest expense		1,460			2,004			2,975			4,208
Net interest income		7,401			7,663			14,694			15,008
Provision for loan losses		100			200			200			300
Net interest income after provision for loan losses		7,301			7,463			14,494			14,708
NON-INTEREST INCOME
Service fees on deposit accounts		935			787			1,836			1,587
Gain on sale of SBA loans		308			48			432			48
Gain on sale of other real estate owned		30			0			31			0
Other income		328			212			550			515
Total		1,601			1,047			2,849			2,150
OPERATING EXPENSES
Salaries and employee benefits		3,384			3,065			6,685			6,424
Occupancy and equipment		1,084			1,019			2,103			2,024
Data processing		375			455			741			866
Legal and other professional fees		116			400			160			725
Telephone, postage and supplies		331			288			611			607
Marketing and promotion		104			80			179			217
Amortization of intangibles		85			84			171			171
FDIC insurance and regulatory assessments		42			35			50			71
Other expenses		709			1,051			1,448			1,744
Total operating expenses		6,230			6,477			12,148			12,849
Income before provision for income taxes		2,672			2,033			5,195			4,009
Provision for income taxes		1,006			756			1,951			1,501
Net income		$	1,666		$	1,277		$	3,244		$	2,508
Net income per share — basic		$	0.41		$	0.31		$	0.79		$	0.60
Net income per share — diluted		$	0.38		$	0.30		$	0.74		$	0.58
Cash dividends per share of common stock		$	0.01		$	0.01		$	0.02		$	0.02

 

See notes to consolidated financial statements.

 

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BUSINESS BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
Dollars in thousands		2003			2002			2003			2002
Net income		$	1,666		$	1,277		$	3,244		$	2,508
Other comprehensive income:
Unrealized net gains on securities:
Unrealized net holding gains arising during period (net of taxes of $445 and $607 for the three months ended June 30, 2003 and 2002, and $368 and $786 for the six months ended June 30, 2003 and 2002, respectively)		737			1,025			611			1,314
Comprehensive income		$	2,403		$	2,302		$	3,855		$	3,822

 

See notes to consolidated financial statements.

 

5

 

BUSINESS BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		For the Six Months Ended June 30,
		2003			2002
		(Dollars in thousands)
Cash flows — operating activities
Net income		$	3,244		$	2,508
Reconcilement of net income to net cash from operations:
Provision for loan losses		200			300
Depreciation and amortization		932			799
Net amortization/accretion of premiums/discounts on investment securities		2,781			1,607
Deferred income taxes		—			188
Gain on sale of other real estate owned		(31		)	—
Gain on sale of loans		(432		)	(48		)
Changes in:
Accrued interest receivable and other assets		527			(242		)
Accrued interest payable and other liabilities		(738		)	(1,062		)
Deferred loans fees and discounts, net		351			(45		)
Operating cash flows, net		6,834			4,005
Cash flows — investing activities
Available for sale securities:
Maturities		1,000			22,909
Principal reduction of mortgage-backed securities		47,449			26,716
Purchases		(62,170		)	(35,044		)
Other securities		(626		)	627
Loans, net		(23,429		)	(11,032		)
Proceeds from sale of other real estate owned		86			—
Proceeds from sale of loans		6,662			959
Purchase of bank owned life insurance policies		(3,881		)	—
Purchase of property, premises and equipment		(1,007		)	(1,942		)
Investing cash flows, net		(35,916		)	3,193
Cash flows — financing activities
Net change in deposits		22,109			3,112
Net change in other borrowings		10,100			(6,299		)
Proceeds from the exercise of stock options		384			998
Cash dividends		(85		)	(82		)
Repurchases of common stock		(2,874		)	(4,661		)
Financing cash flows, net		29,634			(6,932		)
Net change in cash and cash equivalents		552			266
Cash and cash equivalents at beginning of period		32,531			34,615
Cash and cash equivalents at end of period		$	33,083		$	34,881
Cash flows —supplemental disclosures
Interest on deposits, borrowings and trust preferred securities		$	3,223		$	4,726
Income taxes		$	2,240		$	1,205
Non-cash transactions:
Stock dividends paid on common stock		4,234			$	2,689

 

See notes to consolidated financial statements.

 

6

 

BUSINESS BANCORP AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2003

 

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Business Bancorp (“BB”, on a parent-only basis, and “we” or “our”, on a consolidated basis) is a bank holding company with one bank subsidiary: Business Bank of California (the “Bank”). Business Capital Trust I and MCB Statutory Trust I, which are statutory trusts formed for the exclusive purpose of issuing and selling trust preferred securities, are also subsidiaries of ours.  The unaudited consolidated financial information included herein was prepared on the same basis as the audited financial statements for the year ended December 31, 2002.  The interim condensed consolidated financial statements contained herein are not audited.  However, in our opinion, all adjustments, consisting only of normal recurring items necessary for a fair presentation of the operating results for the periods shown, have been made.  The results of operations for the six months ended June 30, 2003 should not be considered indicative of operating results to be expected for the year ending December 31, 2003.  Certain prior year and prior quarter amounts have been reclassified to conform to current classifications.  Cash and cash equivalents consists of cash, due from banks, and federal funds sold.

 

On December 31, 2001, we completed our merger with MCB Financial Corporation.  This merger was accounted for using the purchase accounting method and, accordingly, MCB Financial Corporation’s results of operations have been included in the consolidated financial statements since December 31, 2001.

 

Use of Estimates in the Preparation of Financial Statements

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.

 

Stock-Based Compensation

 

In October 1995, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards (“SFAS”) No. 123 “Accounting for Stock-Based Compensation” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation” (“SFAS No. 123 and No. 148”).  Under the provisions of SFAS No. 123 and No. 148, we are encouraged, but not required, to measure compensation costs related to our employee stock compensation plans under the fair value method.  If we elect not to recognize compensation expense under this method, we are required to disclose the pro forma net income and net income per share effects based on the SFAS No. 123 and No. 148 fair value methodology.  We have elected to adopt the disclosure provisions of these statements.

 

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We apply Accounting Principles Board (“APB”) Opinion No. 25 and related interpretations in our accounting for stock options.  Accordingly, no compensation cost has been recognized for our stock option plan.  Had compensation for our stock option plan been determined consistent with SFAS No. 123 and No. 148, our net income per share would have been reduced to the pro forma amounts indicated below:

 

		Three months ended June 30						Six months ended June 30
(Dollars in thousands, except per share amounts)		2003			2002			2003			2002
Stock-based employee compensation cost, net of tax, that would have been included in the determination of net income if the fair value method had been applied to all awards		$	19		$	15		$	41		$	284
Net income:
As reported		$	1,666		$	1,277		$	3,244		$	2,508
Pro forma		$	1,647		$	1,262		$	3,203		$	2,224
Basic net income per share:
As reported		$	0.41		$	0.31		$	0.79		$	0.60
Pro forma		$	0.40		$	0.31		$	0.78		$	0.53
Diluted net income per share:
As reported		$	0.38		$	0.30		$	0.74		$	0.58
Pro forma		$	0.38		$	0.29		$	0.73		$	0.51

 

The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted average assumptions for grants during the periods indicated:

 

		Three months ended June 30
		2003		2002
Dividend yield		0.20	%	0.28	%
Expected volatility		22.00	%	20.00	%
Risk free rates		2.99	%	3.39	%
Weighted average expected life		7.5 yrs		7.5 yrs

 

No adjustments have been made for forfeitures.  The actual value, if any, that the option holder will realize from these options will depend solely on the increase in the common share stock price over the option price when the options are exercised.

 

8

 

Goodwill and Other Intangible Assets

 

Goodwill generated from purchase business combinations consummated prior to the issuance of Statement of Financial Accounting Standards (“SFAS”) No. 142 “Goodwill and Other Intangible Assets,” (“SFAS No. 142”) was amortized straight-line over 15 to 20 years.  SFAS No. 142 addresses the initial recognition and measurement of goodwill and other intangible assets acquired as a result of a business combination and the recognition of and measurement of those assets subsequent to acquisition.  Under the new standard, goodwill and other intangible assets deemed to have indefinite lives will no longer be amortized, but instead they will be tested at least annually for impairment.  Upon adoption of SFAS No. 142, we did not identify any existing intangible assets to be separated from goodwill.

 

SFAS No. 142 also requires an analysis of impairment of goodwill annually or more frequently upon the occurrence of certain events.  During 2002, we completed the required initial impairment tests of goodwill and an annual update was completed in 2003.  Based upon our latest evaluation, our goodwill was not impaired at June 30, 2003.  We have no indefinite-lived other intangible assets.

 

NOTE 2 – BUSINESS COMBINATIONS

 

On December 31, 2001, we completed our merger with MCB Financial Corporation for a purchase price of $28.5 million.  We issued 1.9 million shares of our common stock for 100 percent of the outstanding common shares of MCB Financial Corporation.  The merger was accounted for using the purchase method of accounting and, accordingly, MCB Financial Corporation’s results of operations have been included in the consolidated financial statements since the date of the merger.

 

The purchase price for MCB Financial Corporation has been allocated to the assets acquired and liabilities assumed based on the estimated fair values at the date of the merger.  The excess of purchase price over the estimated fair values of the net assets acquired, totaling $14.1 million, was recorded as goodwill.  Prospectively, goodwill will be evaluated for possible impairment under the provisions of SFAS No. 142.

 

NOTE 3 – BORROWINGS

 

The following table presents our borrowings in detail for the periods indicated:

 

(Dollars in thousands)		June 30, 2003			December 31, 2002
Short term borrowings:
FHLB advances		$	33,725		$	20,025
Long term borrowings:
FHLB advances		—			3,600
Total borrowings		$	33,725		$	23,625

 

9

 

Pursuant to collateral agreements with the Federal Home Loan Bank (the “FHLB”), advances are secured by all the capital stock in the FHLB and certain investment securities.  Four advances totaling $33,725,000 were outstanding from the FHLB at June 30, 2003.  One advance for $17,500,000 bears an interest rate of 1.02% and matured July 1, 2003; one advance for $10,000,000 bears an interest rate of 1.05% and matures October 6, 2003; one advance for $2,625,000 bears an interest rate of 5.76% and matures December 22, 2003; and one advance for $3,600,000 bears an interest rate of 5.37% and matures January 12, 2004.

 

NOTE 4 – EARNINGS PER SHARE

 

Basic earnings per share is computed by dividing net income by the number of weighted average common shares outstanding.  Diluted earnings per share reflects potential dilution from outstanding stock options, using the treasury stock method.  The number of weighted average shares used in computing basic and diluted earnings per share are as follows:

 

		Three months ended June 30,
		2003								2002
Dollars in thousands except share and per share amounts		Income (numerator)			Shares (denominator)		Per Share Amount			Income (numerator)			Shares (denominator)		Per Share Amount
Net Income as Reported		$	1,666							$	1,277
Used in Basic EPS		1,666			4,072,295		$	0.41		1,277			4,084,823		$	0.31
Dilutive Effect of Outstanding
Stock Options					310,605								201,691
Used in Dilutive EPS		$	1,666		4,382,900		$	0.38		$	1,277		4,286,514		$	0.30

 

		Six months ended June 30,
		2003								2002
Dollars in thousands except share and per share amounts		Income (numerator)			Shares (denominator)		Per Share Amount			Income (numerator)			Shares (denominator)		Per Share Amount
Net Income as Reported		$	3,244							$	2,508
Used in Basic EPS		3,244			4,105,786		$	0.79		2,508			4,161,288		$	0.60
Dilutive Effect of Outstanding
Stock Options					279,827								193,405
Used in Dilutive EPS		$	3,244		4,385,613		$	0.74		$	2,508		4,354,693		$	0.58

 

NOTE 5 – GUARANTEES

 

In November 2002, the FASB issued FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees Including Indirect Guarantees of Indebtedness to Others” (“FIN 45”), which requires us to disclose information about obligations under certain guarantee arrangements.  FIN 45 defines a guarantee as a contract that contingently requires us to pay a guaranteed party based on:

 

1.               changes in underlying asset, liability or equity security of the guaranteed party or

2.               a third party’s failure to perform under an obligating guarantee (performance guarantee).

 

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We provide guarantees related to financial and performance standby letters of credit issued to our customers to enhance their credit standing and enable them to complete a wide variety of business transactions.  Financial standby letters of credit are conditional commitments issued by us to guarantee the payment by a client to a third party (beneficiary).  Financial standby letters of credit are primarily used to support many types of domestic and international payments.  Performance standby letters of credit are issued to guarantee the performance of a customer to a third party when certain specified future events have occurred.  Performance standby letters of credit are primarily used to support performance instruments such as bid bonds, performance bonds, lease obligations, repayment of loans and past due notices.  These standby letters of credit have fixed expiration dates and generally require a fee paid by a customer at the time we issue the commitment.

 

The credit risk involved in issuing letters of credit is essentially the same as that involved with extending loan commitments to customers, and accordingly, we use a credit evaluation process and collateral requirements similar to those for loan commitments.  The actual liquidity needs or the credit risk that we have experienced historically has been lower than the contractual amount of letters of credit issued because a significant portion of these conditional commitments expire without being drawn upon.

 

The table below summarizes at June 30, 2003 our standby letter of credits at the inception of the contract.  The maximum potential amount of future payments represents the amount that could be lost under the standby letter of credits if there were a total default by the guaranteed parties, without consideration of possible recoveries under recourse provisions or from the collateral held or pledged.

 

		Expires within one year			Expires after one year			Total amount outstanding			Maximum amount of future payments
		(dollars in thousands)
Financial standby		—			—			—			—
Peformance standby		$	3,039		$	80		$	3,119		$	3,119
Total		$	3,039		$	80		$	3,119		$	3,119

 

NOTE 6 – VARIABLE INTEREST ENTITIES

 

FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”) defines variable interest entities as a corporation, partnership, trust or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities.  A variable interest entity often holds financial assets, including loans or receivables, real estate or other property.  A variable interest entity may be essentially passive or it may engage in research and development or other activities on behalf of another company.  FIN 46 requires that a variable interest entity be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or entitled to receive a majority of the entity’s residual returns or both.  FIN 46 also requires disclosures about variable

 

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interest entities that we are not required to consolidate but in which we have a significant variable interest.  As of June 30, 2003, we did not have an interest in any variable interest entities.

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis is intended to provide greater details of our results of operations and financial condition.  The following discussion should be read in conjunction with our consolidated financial data included elsewhere in this document.  Certain statements under this caption constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which involve risks and uncertainties.  Our actual results may differ significantly from the results discussed in such forward-looking statements.  Factors that might cause such a difference include but are not limited to economic conditions, competition in the geographic and business areas in which we conduct our operations, fluctuation in interest rates, credit quality and government regulation and other factors discussed in our Annual Report on Form 10-K for the year ended December 31, 2002.

 

Overview

 

Business Bancorp (“BB”, on a parent-only basis, and “we” or “our”, on a consolidated basis) is a bank holding company with one bank subsidiary: Business Bank of California (the “Bank”). Business Capital Trust I and MCB Statutory Trust I, which are statutory trusts formed for the exclusive purpose of issuing and selling trust preferred securities, are also subsidiaries of ours.

 

We provide a wide range of commercial banking services to small and medium-sized businesses, real estate developers, property managers, business executives, professionals and other individuals.  We operate throughout the San Francisco Bay Area and Southern California’s Inland Empire with fifteen branch offices located in Corona, Hayward, Hemet, Hesperia, Ontario, Petaluma, Phelan, Redlands, Riverside, San Bernardino, San Francisco, San Rafael, South San Francisco and Upland.

 

At June 30, 2003, we had total assets of $663.7 million, total loans, net, of $389.2 million and total deposits of $552.9 million.

 

RESULTS OF OPERATIONS

 

The following table summarizes our income, income per share and key financial ratios for the periods indicated:

 

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		Net Income						Net Income
Dollars in thousands, except per share amounts		Three months ended June 30,						Six months ended June 30,
		2003			2002			2003			2002
Income		$	1,666		$	1,277		$	3,244		$	2,508
Income per share:
Basic		$	0.41		$	0.31		$	0.79		$	0.60
Diluted		$	0.38		$	0.30		$	0.74		$	0.58
Return on average assets		1.03		%	0.83		%	1.03		%	0.81		%
Return on average shareholders’ equity		11.22		%	9.59		%	11.00		%	9.36		%
Dividend payout ratio		2.63		%	3.33		%	2.70		%	3.45		%

 

Net Income

 

Our net income for the second quarter of 2003 increased 30.5% to $1,666,000, or $0.38 per diluted share, compared to net income of $1,277,000, or $0.30 per diluted share, for the second quarter of 2002.  Based on our net income for the second quarter of 2003, our return on average shareholders’ equity was 11.22% and our return on average assets was 1.03%.  During the second quarter of 2002, our net income resulted in a return on average shareholders’ equity of 9.59% and a return on average assets of 0.83%.

 

The increase in net income during the second quarter of 2003 as compared to the second quarter of 2002 was primarily due to increases in noninterest income and decreases in noninterest expense.

 

Our net income for the six months ended June 30, 2003 increased 29.4% to $3,244,000, or $0.74 per diluted share, compared to net income of $2,508,000, or $0.58 per diluted share, for the six months ended June 30, 2002.  Based on our net income for the six months ended June 30, 2003, our return on average shareholders’ equity was 11.00% and our return on average assets was 1.03%.  During the six months ended June 30, 2002, our net income resulted in a return on average shareholders’ equity of 9.36% and a return on average assets of 0.81%.

 

The increase in net income during the six months ended June 30, 2003 as compared to the six months ended June 30, 2002 was primarily due to increases in noninterest income and decreases in noninterest expense.

 

Net Interest Income - Quarterly

 

Our net interest income decreased 3.4% to $7.4 million for the second quarter of 2003 from $7.7 million for the second quarter of 2002.  The increase in our average interest-earning assets was offset by the 35 basis point drop in our net yield on interest-earning assets.

 

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Our net interest income increased 1.5% to $7.4 million for the second quarter of 2003 from $7.3 million for the first quarter of 2003.  The increase in our average interest-earning assets was partially offset by the 11 basis point drop in our net yield on interest-earning assets.

 

The following table presents, for the periods indicated, our condensed average balance sheet information together with interest income and yields earned on average interest-earning assets and interest expense and rates paid on average interest-bearing liabilities.  Average balances are average daily balances.

 

		For the three months ended June 30, 2003								For the three months ended March 31, 2003								For the three months ended June 30, 2002
Dollars in thousands		Average Balance (1)			Interest			Yield / Rate		Average Balance (1)			Interest			Yield / Rate		Average Balance (1)			Interest			Yield / Rate
ASSETS
Federal funds sold		$	711		$	2		1.13	%	$	—		—			—		$	1,331		$	5		1.51	%
Interest earning deposits		192			1			2.09	%	945			$	2		0.86	%	1,434			4			1.12	%
Investment securities:
Taxable		155,689			965			2.49	%	147,351			1,148			3.16	%	136,622			1,645			4.83	%
Tax-exempt (2)		28,618			335			4.70	%	27,493			331			4.88	%	21,220			272			5.14	%
Loans, net (3)		385,050			7,558			7.87	%	379,898			7,327			7.82	%	392,041			7,741			7.92	%
Total Interest-earning Assets		570,260			8,861			6.23	%	555,687			8,808			6.43	%	552,648			9,667			7.02	%
Total Non-earning Assets		76,117								70,121								68,143
Total Assets		$	646,377							$	625,808							$	620,791
LIABILITIES & SHAREHOLDERS’ EQUITY
MMDA, NOW and savings		$	265,026		$	615		0.93	%	$	247,233		$	603		0.99	%	$	256,680		$	906		1.42	%
Time certificates, $100,000 or more		60,572			150			0.99	%	62,456			189			1.23	%	65,593			325			1.99	%
Other time certificates		35,079			218			2.49	%	36,295			247			2.76	%	41,849			271			2.60	%
Total Interest-bearing Deposits		360,677			983			1.09	%	345,984			1,039			1.22	%	364,122			1,502			1.65	%
Other borrowings		21,078			135			2.57	%	21,484			138			2.61	%	16,897			160			3.80	%
Trust preferred securities		13,449			342			10.20	%	13,425			338			10.21	%	13,483			342			10.17	%
Total Interest-bearing Liabilities		395,204			1,460			1.48	%	380,893			1,515			1.61	%	394,502			2,004			2.04	%
Non-interest bearing demand deposits		188,605								181,386								169,221
Other non-interest bearing liabilities		3,018								4,162								3,667
Shareholders’ equity		59,550								59,367								53,401
Total liabilities and shareholders’ Equity		$	646,377							$	625,808							$	620,791
Net interest income					$	7,401							$	7,293							$	7,663
Interest rate spread								4.75	%							4.82	%							4.98	%
Contribution of interest free funds								0.45	%							0.51	%							0.58	%
Net yield on interest-earning assets (4)								5.21	%							5.32	%							5.56	%

 

(1)          Nonaccrual loans are excluded from the average balance and only collected interest on nonaccrual loans is included in the interest column.

(2)          Tax equivalent yields earned on the tax exempt securities were 6.40%, 6.66% and 7.01% for the three months ended June 30, 2003, March 31, 2003 and June 30, 2002, respectively, using the federal statutory rate of 34%.

(3)          Loan fees totaling $744,000, $813,000 and $659,000 are included in loan interest income for the three months ended June 30, 2003, March 31, 2003 and June 30, 2002, respectively.

(4)          Net yield on interest-earning assets during the period equals (a) the difference between interest income on interest-earning assets and the interest expense on interest-bearing liabilities, divided by (b) average interest-earning assets for the period.

 

 

14

 

 

The most significant impact on our net interest income between periods is derived from the interaction of changes in the volume of, and rate earned or paid on, interest-earning assets and interest-bearing liabilities. The volume of interest-earning asset dollars in loans and investments, compared to the volume of interest-bearing liabilities represented by deposits and borrowings, combined with the spread, produces the changes in the net interest income between periods. The table below sets forth, for the periods indicated, a summary of the changes in average asset and liability balances (volume) and changes in average interest rates (rate).

 

		Three Months Ended June 30, 2003 Compared to Three Months Ended March 31, 2003 Favorable / (Unfavorable)									Three Months Ended June 30, 2003 Compared to Three Months Ended June 30, 2002 Favorable / (Unfavorable)
Dollars in thousands		Volume			Rate (1)			Total			Volume			Rate (1)			Total
Interest Income:
Federal funds sold		$	2		$	0		$	2		$	(2	)	$	(1	)	$	(3	)
Interest earning deposits		(2		)	1			(1		)	(3		)	0			(3		)
Investment securities:
Taxable		66			(249		)	(183		)	230			(910		)	(680		)
Tax-exempt		14			(10		)	4			95			(32		)	63
Loans, net		100			131			231			(138		)	(45		)	(183		)
Total Interest Income		180			(127		)	53			182			(988		)	(806		)
Interest Expense:
MMDA, NOW and savings		(44		)	32			(12		)	(30		)	321			291
Time certificates, $100,000 or more		6			33			39			25			150			175
Other time certificates		8			21			29			44			9			53
Other borrowings		3			0			3			(40		)	65			25
Trust preferred securities		(1		)	(3		)	(4		)	1			(1		)	0
Total Interest Expense		(28		)	83			55			0			544			544
Change in Net Interest Income		$	152		$	(44	)	$	108		$	182		$	(444	)	$	(262	)

 

(1)             The rate/volume variance has been included in the rate variance.

 

The Quarter Ended June 30, 2003 Compared to the Quarter Ended June 30, 2002

 

Interest income in the second quarter ended June 30, 2003 decreased to $8.9 million from $9.7 million in the quarter ended June 30, 2002.  This was primarily due to the decrease in the yield earned on average interest-earning assets. The yield on average interest-earning assets decreased from 7.02% during the second quarter ended June 30, 2002 to 6.23% during the second quarter ended June 30, 2003.  This decline reflects the general decline in market interest rates during 2002 and 2003.  Loans represented approximately 67.5% of total interest-earning assets in the second quarter of 2003 compared to 70.9% for the second quarter of 2002.

 

15

 

Interest expense in the second quarter of 2003 decreased to $1.5 million from $2.0 million for the second quarter of 2002.  This decrease was entirely due to the decrease in the rates paid on interest-bearing liabilities.  Interest rates paid on average interest-bearing liabilities decreased to 1.48% during the second quarter of 2003 from 2.04% during the same period of 2002.  This decline reflects the general decline in market interest rates during 2002 and 2003.

 

As a result of the foregoing analyses, our net yield on interest-earning assets decreased in the second quarter of 2003 to 5.21% from 5.56% in the the second quarter of 2002.

 

The Quarter Ended June 30, 2003 Compared to the Quarter Ended March 31, 2003

 

Interest income in the second quarter ended June 30, 2003 increased to $8.9 million from $8.8 million in the first quarter ended March 31, 2003.  The increase was primarily due to an increase in average interest-earning assets partially offset by a decrease in the yield earned on average interest-earning assets.  Average interest-earning assets increased to $570.3 million during the three months ended June 30, 2003 compared to $555.7 during the three months ended March 31, 2003.  The yield earned on average interest-earning assets declined to 6.23% in the three months ended June 30, 2003 compared to 6.43% in the three months ended March 31, 2003.  This decline reflects the general decline in market interest rates during the second quarter of 2003.  Loans represented approximately 67.5% of average interest-earning assets in the second quarter of 2003 compared to 68.4% in the first quarter of 2003.

 

Interest expense in the second quarter of 2003 remained unchanged at $1.5 million compared to the first quarter of 2003.  An increase in average interest-bearing liabilities was offset by a decrease in the rates paid on interest-bearing liabilities.  Average interest-bearing liabilities increased to $395.2 million during the second quarter of 2003 compared to $380.9 during the first quarter of 2003.  Interest rates paid on average interest-bearing liabilities decreased to 1.48% during the second quarter of 2003 from 1.61% during the first quarter of 2003.  This decline reflects the general decline in market interest rates during the second quarter of 2003.

 

As a result of the foregoing analyses, our net yield on interest-earning assets decreased in the second quarter of 2003 to 5.21% from 5.32% in the first quarter of 2003.

 

Net Interest Income – Year to Date

 

Our net interest income decreased 2.1% to $14.7 million for the six months ended June 30, 2003 from $15.0 million for the six months ended June 30, 2002.  The increase in our average interest-earning assets was offset by the 21 basis point drop in our net yield on interest-earning assets.

 

The following table presents, for the periods indicated, our condensed average balance sheet information together with interest income and yields earned on average interest-earning

 

16

 

assets and interest expense and rates paid on average interest-bearing liabilities.  Average balances are average daily balances.

 

		For the six months ended June 30, 2003								For the six months ended June 30, 2002
Dollars in thousands		Average Balance (1)			Interest			Yield / Rate		Average Balance (1)			Interest			Yield / Rate
ASSETS
Federal funds sold		$	357		$	2		1.13	%	$	1,840		$	14		1.53	%
Interest earning deposits		566			2			0.71	%	1,088			5			0.93	%
Investment securities:
Taxable		151,543			2,113			2.81	%	138,339			3,233			4.71	%
Tax-exempt (2)		28,058			666			4.79	%	21,345			543			5.13	%
Loans, net (3)		382,488			14,886			7.85	%	391,066			15,421			7.95	%
Total Interest-earning Assets		563,012			17,669			6.33	%	553,678			19,216			7.00	%
Total Non-earning Assets		73,137								67,193
Total Assets		$	636,149							$	620,871
LIABILITIES & SHAREHOLDERS’ EQUITY
MMDA, NOW and savings		$	256,178		$	1,217		0.96	%	$	251,418		$	1,773		1.42	%
Time certificates, $100,000 or more		61,508			483			1.58	%	69,027			759			2.22	%
Other time certificates		35,684			321			1.81	%	42,161			595			2.85	%
Total Interest-bearing Deposits		353,370			2,021			1.15	%	362,606			3,127			1.74	%
Other borrowings		21,280			274			2.60	%	22,347			401			3.62	%
Trust preferred securities		13,437			680			10.21	%	13,487			680			10.17	%
Total Interest-bearing Liabilities		388,087			2,975			1.55	%	398,440			4,208			2.13	%
Non-interest bearing demand deposits		185,016								164,365
Other non-interest bearing liabilities		3,587								4,013
Shareholders’ equity		59,459								54,053
Total liabilities and shareholders’ Equity		$	636,149							$	620,871
Net interest income					$	14,694							$	15,008
Interest rate spread								4.78	%							4.87	%
Contribution of interest free funds								0.48	%							0.60	%
Net yield on interest-earning assets (4)								5.26	%							5.47	%

 

(1)          Nonaccrual loans are excluded from the average balance and only collected interest on nonaccrual loans is included in the interest column.

(2)          Tax equivalent yields earned on the tax exempt securities were 6.53% and 7.00% for the six months ended June 30, 2003 and June 30, 2002, respectively, using the federal statutory rate of 34%.

(3)          Loan fees totaling $1,558,000 and  $1,241,000 are included in loan interest income for the six months ended June 30, 2003 and June 30, 2002, respectively.

(4)          Net yield on interest-earning assets during the period equals (a) the difference between interest income on interest-earning assets and the interest expense on interest-bearing liabilities, divided by (b) average interest-earning assets for the period.

 

The most significant impact on our net interest income between periods is derived from the interaction of changes in the volume of, and rate earned or paid on, interest-earning assets and interest-bearing liabilities. The volume of interest-earning asset dollars in loans and investments,

 

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compared to the volume of interest-bearing liabilities represented by deposits and borrowings, combined with the spread, produces the changes in the net interest income between periods. The table below sets forth, for the periods indicated, a summary of the changes in average asset and liability balances (volume) and changes in average interest rates (rate).

 

		Six Months Ended June 30, 2003 Compared to Six Months Ended June 30, 2002 Favorable / (Unfavorable)
Dollars in thousands		Volume			Rate (1)			Total
Interest Income:
Federal funds sold		$	(11	)	$	(1	)	$	(12	)
Interest earning deposits		(2		)	(1		)	(3		)
Investment securities:
Taxable		308			(1,428		)	(1,120		)
Tax-exempt		171			(48		)	123
Loans, net		(338		)	(197		)	(535		)
Total Interest Income		128			(1,675		)	(1,547		)
Interest Expense:
MMDA, NOW and savings		(34		)	590			556
Time certificates, $100,000 or more		83			193			276
Other time certificates		92			182			274
Other borrowings		19			108			127
Trust preferred securities		3			(3		)	0
Total Interest Expense		163			1,070			1,233
Change in Net Interest Income		$	291		$	(605	)	$	(314	)

 

(1)          The rate/volume variance has been included in the rate variance.

 

The Six Months Ended June 30, 2003 Compared to the Six Months Ended June 30, 2002

 

Interest income during the six months ended June 30, 2003 decreased to $17.7 million from $19.2 million during the six months ended June 30, 2002.  This was primarily due to the decrease in the yield earned on average interest-earning assets. The yield on average interest-earning assets decreased from 7.00% during the six months ended June 30, 2002 to 6.33% during the six months ended June 30, 2003.  This decline reflects the general decline in market interest rates during 2002 and 2003.  Loans represented approximately 67.9% of total interest-earning assets during the six months ended June 30, 2003 compared to 70.6% for the same period in the prior year.

 

Interest expense during the first six months of 2003 decreased to $3.0 million from $4.2 million during the first six months of 2002.  This decrease was primarily due to the decrease in the rates paid on interest-bearing liabilities.  Interest rates paid on average interest-bearing liabilities decreased to 1.55% during the first six months of 2003 from 2.13% during the same period of 2002.  This decline reflects the general decline in market interest rates during 2002 and 2003.

 

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As a result of the foregoing analyses, our net yield on interest-earning assets decreased during the first six months of 2003 to 5.26% from 5.47% during the same period of 2002.

 

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Noninterest Income

 

The following table summarizes our noninterest income for the periods indicated and expresses the amounts as a percentage of average assets:

 

		Three Months Ended June 30						Six Months Ended June 30
Dollars in thousands		2003			2002			2003			2002
Components of Noninterest Income
Service fees on deposit accounts		$	935		$	787		$	1,836		$	1,587
Gain on sale of SBA loans		308			48			432			48
Gain on sale of other real estate owned		30						31
Other income		328			212			550			515
Total		$	1,601		$	1,047		$	2,849		$	2,150
As a Percentage of Average Assets (Annualized)
Service fees on deposit accounts		0.58		%	0.51		%	0.58		%	0.52		%
Gain on sale of SBA loans		0.19		%	0.03		%	0.14		%	0.02		%
Gain on sale of other real estate owned		0.02		%				0.01		%
Other income		0.20		%	0.14		%	0.17		%	0.17		%
Total		0.99		%	0.68		%	0.90		%	0.70		%

 

Our noninterest income increased to $1.6 million in the second quarter of 2003 from $1.0 million in the same period of 2002.  For the six months ended June 30, 2003, our noninterest income increased to $2.8 million from $2.2 million in the same period of 2002.  Increases in service fees on deposit accounts and gains on sales of SBA loans accounted for most of the increases.

 

Operating Expenses

 

The following table summarizes our operating expenses and the associated ratios to average assets for the periods indicated:

 

20

 

 

		Three Months Ended June 30						Six Months Ended June 30
Dollars in thousands		2003			2002			2003			2002
Components of Operating Expense
Salaries and employee benefits		$	3,384		$	3,065		$	6,685		$	6,424
Occupancy and equipment		1,084			1,019			2,103			2,024
Data processing		375			455			741			866
Legal and other professional fees		116			400			160			725
Telephone, postage and supplies		331			288			611			607
Marketing and promotion		104			80			179			217
Amortization of intangibles		85			84			171			171
FDIC insurance and regulatory assessments		42			35			50			71
Other expenses		709			1,051			1,448			1,744
Total Noninterest Expense		$	6,230		$	6,477		$	12,148		$	12,849
Average full-time equivalent staff		219			224			217			226
As a Percentage of Average Assets (Annualized)
Salaries and employee benefits		2.10		%	1.98		%	2.12		%	2.09		%
Occupancy and equipment		0.67		%	0.66		%	0.67		%	0.66		%
Data processing		0.23		%	0.29		%	0.23		%	0.28		%
Legal and other professional fees		0.07		%	0.26		%	0.05		%	0.24		%
Telephone, postage and supplies		0.21		%	0.19		%	0.19		%	0.20		%
Marketing and promotion		0.06		%	0.05		%	0.06		%	0.07		%
Amortization of intangibles		0.05		%	0.05		%	0.05		%	0.06		%
FDIC insurance and regulatory assessments		0.03		%	0.02		%	0.02		%	0.02		%
Other expenses		0.44		%	0.68		%	0.46		%	0.57		%
Total		3.87		%	4.18		%	3.85		%	4.17		%
Efficiency ratio		69.21		%	74.36		%	69.25		%	74.89		%

 

Our operating expenses decreased by $247,000, or 3.8%, in the second quarter of 2003 compared to the same period of 2002.  Legal and other professional fees decreased $284,000, or 71.0%.  During the second quarter of 2002, we recorded $285,000 in costs associated with the merger with MCB Financial Corporation and the on-going integration effort.

 

For the six months ended June 30, 2003, our operating expenses decreased by $701,000, or 5.5%, compared to the same period in 2002.  Legal and other professional fees decreased $565,000, or 78.0%.  During the six months ended June 30, 2002, we recorded $510,000 in costs associated with the merger with MCB Financial Corporation and the on-going integration effort.

 

Income Taxes.

 

Our effective tax rate was 37.6% for the second quarter ended June 30, 2003 compared to 37.2% for the same period of the prior year.  For the six months ended June 30, 2003, our effective tax rate was 37.6% compared to 37.4% for the same period in the prior year.

 

21

 

FINANCIAL CONDITION

 

Our total assets increased by $32.7 million, or 5.2%, from $630.9 million at the end of 2002 to $663.7 million at June 30, 2003.  The increase in total assets was primarily due to the $22.1 million increase in total deposits and the $10.1 million increase in borrowings.

 

Investments

 

The following tables set forth the amortized cost and approximate market value of our investment securities as of the dates indicated:

 

Dollars in thousands June 30, 2003:		Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses			Estimated Fair Value			Carrying Value
Available for sale:
U.S. Treasury securities		$	2,006		$	6					$	2,012		$	2,012
Mortgage backed securities		155,285			2,354			$	(679	)	156,960			156,960
Municipal securities		26,668			3,002			(3		)	29,667			29,667
Corporates		2,031			487						2,518			2,518
Total Available for Sale		$	185,990		$	5,849		$	(682	)	$	191,157		$	191,157

 

Dollars in thousands December 31, 2002		Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses				Estimated Fair Value			Carrying Value
Available for sale:
U.S. Treasury securities		$	3,033		$	20		$				$	3,053		$	3,053
Mortgage backed securities		144,257			$	2,495		$		(340	)	146,412			146,412
Municipal securities		25,729			1,705			(64			)	27,370			27,370
Corporates		2,031			314							2,345			2,345
Total Available for Sale		$	175,050		$	4,534		$		(404	)	$	179,180		$	179,180

 

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Dollars in thousands June 30, 2002		Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses			Estimated Fair Value			Carrying Value
Available for sale:
U.S. Treasury securities		$	3,075		$	16					$	3,091		$	3,091
U.S. government agencies		1,051			12						1,063			1,063
Mortgage backed securities		123,556			2,582			$	(36	)	126,102			126,102
Municipal securities		20,434			1,248						21,682			21,682
Other securities		2,031			157						2,188			2,188
Total Available for Sale		$	150,147		$	4,015		$	(36	)	$	154,126		$	154,126
Held to Maturity:
U.S. Treasury securities		$	1,009		$	2		$			$	1,011		$	1,009
Total Held to Maturity		$	1,009		$	2		$			$	1,011		$	1,009

 

Loans Held for Investment

 

Our loans, net of deferred fees, increased by $16.7 million, or 4.4%, during the first six months of 2003.  The following table presents the composition of our loan portfolio at the date indicated:

 

		June 30 2003					December 31 2002						June 30 2002
Dollars in thousands		Amount			%		Amount				%		Amount			%
Real estate — construction		$	65,602		16.6	%	$	59,854			15.8	%	$	76,234		19.2	%
Commercial real estate		267,979			67.9		253,105				66.9		226,108			56.9
Real estate — other		19,826			5.0		25,951				6.9		40,766			10.3
Commercial		37,640			9.5		33,441				8.8		43,832			11.0
Consumer and other		5,140			1.3		6,791				1.8		11,841			3.0
Total loans, gross		396,187			100.4		379,142				100.3		398,781			100.3
Less: unearned income		(1,393		)	(0.4	)	(1,042		)		(0.3	)	(1,064		)	(0.3	)
Total loans, net of deferred fees		$	394,794		100.0		$	378,100			100.0		$	397,717		100.0

 

In the normal practice of extending credit, we accept real estate collateral for loans which have primary sources of repayment from commercial operations.  The total amount of loans secured by real estate equaled $353.4 million, or 89.2% of the total portfolio as of June 30, 2003.  Due to our limited marketing areas, our real estate collateral is primarily concentrated in the San Francisco Bay Area and Southern California.  We believe that our underwriting standards for real estate secured loans are prudent and provide an adequate safeguard against declining real estate prices which may effect a borrower’s ability to liquidate the property and repay the loan.  However, no assurance can be given that real estate values will not decline and impair the value of the security for loans held by us.

 

We focus our portfolio lending on commercial, commercial real estate, and construction loans.  These loans generally carry a higher level of risk than conventional real estate loans; accordingly, yields on these loans are typically higher than those of other loans.  The

 

23

 

performance of commercial and construction loans is generally dependent upon future cash flows from business operations (including the sale of products, merchandise and services) and the successful completion or operation of real estate projects.  Risks attributable to such loans can be significantly increased, often to a greater extent than other loans, by regional economic factors, real estate prices, the demand for commercial and retail office space, and the demand for products and services of industries which are concentrated within our loan portfolio.  Because credit concentrations increase portfolio risk, we place significant emphasis on the purpose of each loan and the related sources of repayment.  We generally limit unsecured commercial loans to maturities of three years and secured commercial loans to maturities of five years.

 

Maturities of Loans at June 30, 2003:

 

Dollars in thousands

 

Time remaining to maturity		Fixed rate			Adjustable rate			Total
One year or less		$	24,099		$	106,603		$	130,702
After one year to five years		85,363			36,936			122,299
After five years		37,416			105,770			143,186
Total		$	146,878		$	249,309		$	396,187

 

As of June 30, 2003, the percentage of loans held for investment with fixed and floating interest rates was 37.1% and 62.9%, respectively.

 

Nonperforming Assets

 

We carefully monitor the quality of our loan portfolio and the factors that affect it, including regional economic conditions, employment stability, and real estate values.  The accrual of interest on loans is discontinued when the payment of principal or interest is considered to be in doubt, or when a loan becomes contractually past due by 90 days or more with respect to principal or interest, except for loans that are well secured and in the process of collection.

 

As of June 30, 2003, we had $1.8 million in nonperforming assets and one Small Business Administration (“SBA”) loan on nonaccrual status totaling $782,000. This loan is guaranteed by the SBA.  The following table sets forth the balance of nonperforming assets as of the dates indicated:

 

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Dollars in thousands		June 30 2003			March 31 2003			December 31 2002			September 30 2002			June 30 2002
Nonaccrual loans		$	782		$	222		$	797		$	4,194		$	1,775
Loans 90 days or more past due and still accruing		119			122			249			29			54
Total nonperforming loans		901			344			1,046			4,223			1,829
Other real estate owned		940			965			995			1,005			885
Total nonperforming assets		$	1,841		$	1,309		$	2,041		$	5,228		$	2,714
Nonperforming loans as a percentage of total gross loans		0.23		%	0.09		%	0.28		%	1.08		%	0.46		%
Nonperforming assets as a percentage of total assets		0.28		%	0.21		%	0.32		%	0.85		%	0.43		%
Nonperforming assets as a percentage of total gross loans and other real estate owned		0.46		%	0.35		%	0.54		%	1.33		%	0.68		%

 

Allowance for Loan Losses

 

We maintain an allowance for loan losses (“ALL”) which is reduced by credit losses and increased by credit recoveries and by the provision to the ALL which is charged against operations.  Provisions to the ALL and the total of the ALL are based, among other factors, upon our credit loss experience, current economic conditions, the performance of loans within the portfolio, evaluation of loan collateral value, and the prospects or worth of respective borrowers and guarantors.

 

In determining the adequacy of our ALL and after carefully analyzing each loan individually, we segment the loan portfolio into pools of homogeneous loans that share similar risk factors.  Each pool is given a risk assessment factor which largely reflects the expected future losses from each category.  These risk assessment factors change as economic conditions shift and actual loan losses are recorded.  As of June 30, 2003, the ALL of $5,566,000, or 1.41% of total loans, was determined by us to be adequate against foreseeable future losses.  No assurance can be given that nonperforming loans will not increase or that future losses will not exceed the amount of the ALL.

 

The following table summarizes, for the periods indicated, loan balances at the end of each period and average balances during the period, changes in the ALL arising from credit losses, recoveries of credit losses previously incurred, additions to the ALL charged to operating expense, and certain ratios relating to the ALL:

 

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Dollars in thousands		At and For the Six Months Ended June 30, 2003			At and For the Year Ended December 31, 2002
Allowance for Loan Losses:
Beginning balance		$	5,442		$	4,557
Charge-offs:
Real estate -mortgage		—			60
Commercial		102			65
Consumer and other		11			83
Total Charge-offs		113			208
Recoveries:
Real estate -mortgage		—			55
Commercial		4			25
Consumer and other		33			13
Total Recoveries		37			93
Net Charge-offs  (Recoveries)		76			115
Provision charged to operating expense		200			1,000
Ending balance		$	5,566		$	5,442
Loans at end of period		$	394,794		$	378,100
Average loans during period		$	382,488		$	389,430
Ratios:
Allowance to loans at end of period		1.41		%	1.44		%
Net charge—offs (recoveries) to average loans during period		0.02		%	0.03		%
Net charge—offs (recoveries) to allowance at beginning of period		1.40		%	2.52		%

 

We recorded a provision of $100,000 to the allowance for loan losses during the second quarter of 2003 and $200,000 during the second quarter of 2002.  During the six months ended June 30, 2003 we recorded a provision of $200,000 compared to a provision of $300,000 during the same period of the prior year.  The provisions were recorded due to growth in certain components of the loan portfolio and deteriorating economic conditions in our market areas.

 

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Deposits

 

Our deposits reached $552.9 million at June 30, 2003, an increase of $22.1 million, or 4.2% compared to December 31, 2002.

 

Our noninterest-bearing demand deposit accounts increased 4.4% to $192.8 million at June 30, 2003 compared to $184.7 at December 31, 2002.  The ratio of noninterest-bearing deposits to total deposits increased to 34.9% at June 30, 2003 compared to 34.8% at December 31, 2002.

 

Our MMDA, NOW and savings accounts were 48.0% of total deposits at June 30, 2003 as compared to 46.0% at December 31 2002.  Time certificates of deposit totaled $94.9 million, or 17.2% of total deposits at June 30, 2003 compared to $101.7 million or 19.2% of total deposits at December 31, 2002.

 

Liquidity and Cash Flow

 

The objective of our liquidity management is to maintain our ability to meet the day-to day cash flow requirements of our clients who either wish to withdraw funds or require funds to meet their credit needs. We must manage our liquidity position to allow us to meet the needs of our clients while maintaining an appropriate balance between assets and liabilities to meet the return on investment expectations of our shareholders. We monitor the sources and uses of funds on a daily basis to maintain an acceptable liquidity position. In addition to liquidity from core deposits and repayments and maturities of loans and investments, we have the ability to obtain FHLB advances and purchase overnight Federal Funds.

 

BB is a company separate and apart from the Bank and therefore it must provide for its own liquidity. In addition to its own operating expenses, BB is responsible for the payment of the interest on the outstanding issues of trust preferred securities and the dividends paid on our common stock. Substantially all of BB’s revenues are obtained from dividends declared and paid by the Bank. There are statutory and regulatory provisions that limit the ability of the Bank to pay dividends to BB.  At June 30, 2003, the Bank had approximately $4.9 million in the aggregate available to be paid as dividends to BB. Management of BB believes that such restrictions will not have an impact on the ability of BB to meet its ongoing cash obligations. As of June 30, 2003, BB did not have any material commitments for capital expenditures.

 

Net cash provided by operating activities totaled $6.8 million for the six months ended June 30, 2003 and $4.0 million for the same period in 2002.  Cash used in investing activities totaled $35.9 million in the six months ended June 30, 2003 compared to cash provided by investing activities of $3.2 million for the six months ended June 30, 2002.  For the six months ended June 30, 2003, net cash provided by financing activities was $30.0 million compared to net cash used in financing activities of $6.9 million in the same period of 2002.

 

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

 

Our financial performance is impacted by, among other factors, credit risk and interest rate risk. We do not utilize derivatives to mitigate our credit risk, relying instead on an extensive loan review process and our allowance for loan losses.

 

Interest rate risk is the degree of change in net interest income and economic value of equity due to changes in interest rates. This risk is addressed by our Investment Committee which includes senior management representatives.  We manage the balance sheet, in part, to maintain the forecasted changes in net interest income and economic value of equity within acceptable ranges despite changes in overall interest rates.

 

Our exposure to interest rate risk is reviewed on at least a quarterly basis by the Investment Committee.  Interest rate risk exposure is measured using interest rate sensitivity analysis to determine our change in net interest income and economic value of equity resulting from changes in overall interest rates.  If potential changes to net interest income and economic value of equity resulting from hypothetical changes in overall interest rates are outside of board-approved limits, then the board may advise management to adjust its asset and liability mix to bring the interest rate risk to within Board-approved limits.

 

Net Interest Income Simulation

 

The impact of interest rate changes on net interest income are measured using net interest income simulation.  The various products in our balance sheet are modeled to simulate their income (and cash flow) behavior in relation to changes in interest rates.  Net interest income for the next 12 months is calculated for current interest rates and for immediate and sustained rate shocks.

 

The income simulation model includes various assumptions regarding the repricing relationships for each product. Many of our assets are floating rate loans, which are assumed to reprice immediately, and to the same extent as the change in market rates according to their contracted index. Our non-term deposit products reprice more slowly, usually changing less than the change in market rates and at our discretion.  As of June 30, 2003, our net interest income simulation analysis indicated that our net interest income for the next 12 months would increase by 3.5% if rates increased 100 basis points, and decrease by 1.8% if rates decreased 100 basis points.

 

This analysis calculates changes in net interest income for a given set of market rate changes and assumptions.  It assumes the balance sheet grows modestly, but that its composition remains similar to the composition at year-end.  It does not account for all the factors that impact this analysis including changes that management may make in the balance sheet composition to mitigate the impact of interest rate changes or secondary impacts such as changes to our credit risk profile as interest rates change. Furthermore, loan prepayment rate estimates and spread relationships change regularly.  Interest rate changes create changes in actual loan prepayment rates that will differ from the market estimates incorporated in the analysis. In addition, the proportion of adjustable-rate loans in our portfolio could decrease in future periods if market

 

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interest rates remain at or decrease below current levels. Changes that vary significantly from the assumptions may have significant effects on our net interest income.

 

The results of this sensitivity analysis should not be relied upon as indicative of actual future results.

 

Economic Value of Equity

 

The economic value of equity is computed by estimating the changes in economic, or market, value of equity over a range of potential changes in overall interest rates.  The economic value of equity is the market value of our assets minus the market value of our liabilities.  The market value of each asset and liability is the net present value of the expected future cash flows discounted at market rates after adjustment for rate changes. We measure the impact on market value for an immediate and sustained 100 basis point increase and decrease (“shock”) in interest rates.  As of June 30, 2003, our economic value of equity analysis indicated that our economic value of equity would decrease by 6.1% if rates increased 100 basis points, and increase by 9.0% if rates decreased 100 basis points.

 

The economic value of equity is based on the net present values of each product in the portfolio, which in turn is based on cash flows factoring in recent market prepayment estimates. The discount rates are based on recently observed spread relationships and adjusted for the assumed interest rate changes.

 

Capital Resources

 

Our total shareholders’ equity was $59.7 million as of June 30, 2003 compared to $58.4 million at December 31, 2002.  On February 27, 2003, the Board of Directors approved a plan to expand our stock repurchase program providing for the repurchase of 10% of our common stock outstanding in open market and private transactions.  This program is in addition to the $5 million repurchase program announced in February of 2002.  During the six months ended June 30, 2003, we repurchased 153,000 shares of our common stock for $2.9 million.

 

We declared cash dividends of $0.01 per share during the three months ended June 30, 2003 and $0.02 per share for the six months ended June 30, 2003.

 

We declared a 5% stock dividend during the second quarter of 2002 and during the second quarter of 2003.  All per share amounts have been restated to reflect both 5% stock dividends.

 

 

 

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The ratios of average equity to average assets for the periods indicated are set forth below.

 

Six Months Ended June 30, 2003		Six Months Ended June 30, 2002
9.35%		8.71%

 

Risk-Based Capital

 

Regulatory authorities have issued guidelines to implement risk-based capital requirements.  The guidelines establish a systematic analytical framework that makes regulatory capital requirements more sensitive to differences in risk profiles among banking organizations.

 

Total capital is classified into two components:  Tier 1 (primarily shareholder’s equity) and Tier 2 (supplementary capital including allowance for possible credit losses, certain preferred stock, eligible subordinated debt, and other qualifying instruments).  The guidelines require that total capital be 8% of risk-based assets, of which at least 4% must be Tier 1 capital.  As of June 30, 2003, our total capital ratio was 11.1% and our Tier 1 capital ratio was 10.0%.  In addition, under the guidelines established for adequately capitalized institutions, we must also maintain a minimum leverage ratio (Tier 1 capital divided by average total assets) of 4%.  As of June 30, 2003, our leverage ratio was 7.6%.  It is our intention to maintain risk-based capital ratios at levels characterized as “well-capitalized” for banking organizations:  Tier 1 risk-based capital of 6 percent or above and total risk-based capital at 10 percent or above.

 

The following table shows our actual capital ratios at June 30, 2003 and December 31, 2002 as well as the minimum capital ratios for capital adequacy:

 

Capital to Risk-Adjusted Assets		At June 30, 2003		At December 31, 2002		Minimum Regulatory Capital Requirements
Tier 1 Risk-Based Capital		10.0	%	10.8	%	4.0	%
Total Risk-Based Capital		11.1	%	12.0	%	8.0	%
Leverage Ratio		7.6	%	7.8	%	4.0	%

 

Item 4. Controls and Procedures:

 

We carried out an evaluation under the supervision and with the participation of our management, including our principal executive officer and our principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report, pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934. Based on their review of our disclosure controls and procedures, the principal executive officer and principal financial officer have concluded that our disclosure controls and procedures are effective in timely alerting them to material information relating to us that is required to be included in our periodic SEC filings.

 

There were no changes in our internal controls over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect such controls.

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RECENT ACCOUNTING PRONOUNCEMENTS

 

Accounting for Stock-Based Compensation—Transition and Disclosure

 

In January 2003, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation” (“SFAS No. 148”). SFAS No. 148 amends SFAS No. 123, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. If awards of stock-based employee compensation were outstanding and accounted for under the intrinsic value method of APB Opinion No. 25, “Accounting for Stock” (“APB No. 25”) issued to employees, certain disclosures have to be made for any period for which an income statement is presented.

 

SFAS No. 148 shall be effective for financial statements for fiscal years ending after December 15, 2002. We continue to apply APB No. 25 in accounting for stock-based compensation and have adopted the disclosure requirements of SFAS No. 123 and SFAS No. 148.

 

Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others—an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34

 

In November 2002, the FASB issued FIN 45. FIN 45 addresses the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees. FIN 45 also clarifies the requirements related to the recognition of a liability by a guarantor at the inception of a guarantee for the obligations the guarantor has undertaken in issuing that guarantee.

 

The initial recognition and initial measurement of a liability of a guarantor shall be applied only on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The guarantor’s previous accounting for guarantees issued prior to the date of this Interpretation’s initial application shall not be revised or restated to reflect the effect of the recognition and measurement provisions of the Interpretation.

 

The disclosure requirements in the Interpretation are effective for financial statements of interim or annual periods ending after December 15, 2002. The disclosure requirements of FIN 45 are discussed in Note 5 of the NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. The implementation of the initial recognition provisions of FIN 45 did not have a significant impact on our financial condition or operating results. We do not expect the full adoption of FIN 45 to have a material impact on our financial condition or operating results.

 

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Certain Financial Instruments with Characteristics of both Liabilities and Equity

 

                In May 2003, the FASB issued SFAS No. 150 “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (“SFAS No. 150”).  This statement requires that an issuer classify financial instruments that are within its scope as a liability.  Many of those instruments were classified as equity under previous guidance.  Most of the guidance in SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise effective at the beginning of the first interim period beginning after June 15, 2003.  We are currently evaluating the provisions of this statement, and do not believe that it will have an impact on our consolidated financial statements.

 

Consolidation of Variable Interest Entities

 

In January 2003, the FASB issued FIN 46. FIN 46 explains how to identify variable interest entities and how an enterprise assesses its interests in a variable interest entity to decide whether to consolidate that entity. FIN 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed.

 

 FIN 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003.

 

 FIN 46 may be applied prospectively with a cumulative-effect adjustment as of the date on which it is first applied or by restating previously issued financial statements for one or more years with a cumulative-effect adjustment as of the beginning of the first year restated.

 

We are currently evaluating the impact of FIN 46. The impact of FIN 46 on the treatment of the trust preferred securities we have issued is currently being evaluated by the accounting community. Under one potential interpretation of FIN 46, the trusts which have issued our trust preferred securities would no longer be consolidated. Conversely, SFAS No. 150 requires the consolidation of these subsidiaries and the presentation of the related debt instruments as a liability. The accounting community is currently working to resolve this contradictory guidance. Our current presentation is in compliance with the requirements of SFAS No. 150. One potential impact of not including these trusts in our consolidated liabilities is that the trust preferred securities may no longer count towards Tier 1 capital.  The Federal Reserve has issued regulations which allow for the inclusion of these instruments in Tier 1 capital regardless of the FIN 46 interpretation, although such a determination could potentially be changed at a later date. We do not expect the adoption of FIN 46 to have any additional material impact on our financial condition or operating results.

 

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PART II - OTHER INFORMATION

 

Item 1.  Legal Proceedings

 

None

 

Item 2.  Changes in Securities and Use of Proceeds

 

None

 

Item 3.  Defaults Upon Senior Securities

 

None

 

Item 4.  Submission of Matters to a Vote of Securities Holders

 

(a) Business Bancorp held its annual meeting of shareholders on May 22, 2003.

 

(b) The following directors were elected at the annual meeting to serve for a three-year term:

 

D. William Bader

Neal T. Baker

Catherine H. Munson

 

The following directors continued in office after the annual meeting:

 

John E. Duckworth

Charles O. Hall

Timothy J. Jorstad

Alan J. Lane

Patrick E. Phelan

Gary T. Ragghianti

John L. Riddell

Arnold H. Stubblefield

John L. Stubblefield

Randall J. Verrue

 

(c) At the annual meeting, shareholders approved (1) the election of the Company’s Class 1 directors and (2) the ratification of the selection of Vavrinek, Trine, Day & Company LLP as the Company’s independent auditors for 2003.  The results of the voting were as follows:

 

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Matter		Votes For		Votes Against		Withheld		Abstentions
Election of Directors:
D. William Bader		3,251,850		0		5,819		0
Neil T. Baker		3,251,850		0		5,819		0
Catherine H. Munson		3,251,850		0		5,819		0
Independent Auditors		3,248,867		0				8,752

 

(d) Not applicable

 

Item 5.  Other Information

 

None

 

Item 6. Exhibits and Reports on Form 8-K.

 

(a) Exhibits:  The exhibit index required by this item is incorporated by reference to the Exhibit Index to this report.

 

(b) Reports on Form 8-K.

 

During the quarter ended June 30, 2003, Business Bancorp filed the following Current Reports on Form 8-K: (1) April 22, 2003 (containing a press release announcing first quarter 2003 financial results); (2) May 29, 2003 (containing a press release announcing a cash dividend and stock dividend).

 

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SIGNATURES

 

In accordance with the requirements of the Securities Exchange Act of 1934, as amended, the registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

BUSINESS BANCORP

(Registrant)

 

By:
/s/ Patrick E. Phelan
	Patrick E. Phelan
	Executive Vice President and Chief Financial Officer
Date: August 13, 2003

 

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Exhibit Index

 

Exhibit		Description
10.1		Change in Control Agreement, dated as of May 23, 2003, between Business Bank of California and Cindi Morales
10.2		Change in Control Agreement, dated as of May 28, 2003, between Business Bank of California and Sheila Moran
10.3		Change in Control Agreement, dated as of May 23, 2003, between Business Bank of California and Larry Tidwell
10.4		Change in Control Agreement, dated as of May 27, 2003, between Business Bank of California and David Weiant
10.5		Amended Deferred Compensation Plan Agreement, dated as of June 27, 2003, between Business Bank of California and Charles O. Hall
10.6		Split Dollar Agreement, dated as of May 23, 2003, between Business Bank of California and Alan J. Lane
10.7		Split Dollar Agreement, dated as of May 23, 2003, between Business Bank of California and Charles O. Hall
10.8		Supplemental Executive Retirement Benefits Agreement, dated as of June 27, 2003, between Business Bank of California and Alan J. Lane
10.9		Supplemental Executive Retirement Benefits Agreement, dated as of June 27, 2003, between Business Bank of California and Charles O. Hall
31.1		Certification of Chief Executive Officer Sec 302
31.2		Certification of Chief Financial Officer Sec 302
32.1		Certification of Chief Executive Officer Sec 906
32.2		Certification of Chief Financial Officer Sec 906

 

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