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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from             to             

Commission file number 0-30777

 

 

PACIFIC MERCANTILE BANCORP

(Exact name of Registrant as specified in its charter)

 

 

 

California   33-0898238

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

 

949 South Coast Drive, Suite 300,

Costa Mesa, California

  92626
(Address of principal executive offices)   (Zip Code)

(714) 438-2500

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed, since last year)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports); and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every interactive data file required to be submitted and posted pursuant to Rule 405 of Regulation S-T (section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.) (Check one):

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

10,434,665 shares of Common Stock as of November 6, 2009

 

 

 


Table of Contents

PACIFIC MERCANTILE BANCORP

QUARTERLY REPORT ON FORM 10Q

FOR

THE QUARTER ENDED SEPTEMBER 30, 2009

TABLE OF CONTENTS

 

          Page No.
Part I. Financial Information   

Item 1.

   Financial Statements (unaudited)    1
  

Consolidated Statements of Financial Condition at September 30, 2009 and December 31, 2008

   1
  

Consolidated Statements of Operations for the Three and Nine Months ended September 30, 2009 and 2008

   2
  

Consolidated Statements of Comprehensive Income (Loss) for the Three and Nine Months ended September 30, 2009 and 2008

   3
  

Consolidated Statements of Cash Flows for the Nine Months ended September 30, 2009 and 2008

   4
  

Consolidated Statements of Shareholders’ Equity for the Nine Months ended September 30, 2009

   6
  

Notes to Consolidated Financial Statements

   7

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations    20

Item 3.

   Market Risk    41

Item 4.

   Controls and Procedures    41

Part II. Other Information

  

Item 1

   Legal Proceedings    42

Item 1A.

   Risk Factors    42

Item 6.

   Exhibits    43

Signatures

   S–1

Exhibit Index

   E–1

Exhibit 31.1 Certification of Chief Executive Officer under Section 302 of the Sarbanes–Oxley Act of 2002

 

Exhibit 31.2 Certification of Chief Financial Officer under Section 302 of the Sarbanes–Oxley Act of 2002

 

Exhibit 32.1 Certification of Chief Executive Officer under Section 906 of the Sarbanes–Oxley Act of 2002

 

Exhibit 32.2 Certification of Chief Financial Officer under Section 906 of the Sarbanes–Oxley Act of 2002

  

 

(i)


Table of Contents

PART I. – FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION

(Dollars in thousands)

(Unaudited)

 

     September 30,
2009
    December 31,
2008
 
ASSETS     

Cash and due from banks

   $ 11,051      $ 16,426   

Interest bearing deposits with financial institutions

     79,995        90,707   
                

Cash and cash equivalents

     91,046        107,133   

Interest-bearing time deposits with financial institutions

     16,800        198   

Federal Reserve Bank and Federal Home Loan Bank Stock, at cost

     13,603        13,420   

Securities available for sale, at fair value

     116,483        160,945   

Loans held for sale, at lower of cost or market

     10,598        —     

Loans (net of allowances of $17,180 and $15,453, respectively)

     817,652        828,041   

Investment in unconsolidated subsidiaries

     682        682   

Other real estate owned

     13,992        14,008   

Accrued interest receivable

     4,050        3,834   

Premises and equipment, net

     1,330        1,140   

Other assets

     24,297        34,658   
                

Total assets

   $ 1,110,533      $ 1,164,059   
                
LIABILITIES AND SHAREHOLDERS’ EQUITY     

Deposits:

    

Noninterest-bearing

   $ 179,270      $ 152,462   

Interest-bearing

     678,268        669,224   
                

Total deposits

     857,538        821,686   

Borrowings

     152,000        233,758   

Accrued interest payable

     1,629        2,850   

Other liabilities

     5,461        4,006   

Junior subordinated debentures

     17,527        17,527   
                

Total liabilities

     1,034,155        1,079,827   
                

Commitments and Contingencies (Note 2)

    

Shareholders’ equity:

    

Preferred stock, no par value, 2,000,000 shares authorized, none issued

     —          —     

Common stock, no par value, 20,000,000 shares authorized, 10,434,665 shares issued and outstanding at September 30, 2009 and December 31, 2008

     72,844        72,592   

Retained earnings

     5,116        12,831   

Accumulated other comprehensive loss

     (1,582     (1,191
                

Total shareholders’ equity

     76,378        84,232   
                

Total liabilities and shareholders’ equity

   $ 1,110,533      $ 1,164,059   
                

The accompanying notes are an integral part of these consolidated financial statements.

 

1


Table of Contents

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except for per share data)

(Unaudited)

 

     Three Months Ended
September 30
   Nine Months Ended
September 30
 
     2009     2008    2009     2008  

Interest income:

         

Loans, including fees

   $ 11,936      $ 12,456    $ 35,529      $ 37,582   

Federal funds sold

     —          177      —          796   

Securities available for sale and stock

     814        2,595      2,912        7,877   

Interest-bearing deposits with financial institutions

     129        2      373        7   
                               

Total interest income

     12,879        15,230      38,814        46,262   

Interest expense:

         

Deposits

     5,701        5,508      17,699        17,459   

Borrowings

     1,794        2,738      5,922        8,420   
                               

Total interest expense

     7,495        8,246      23,621        25,879   
                               

Net interest income

     5,384        6,984      15,193        20,383   
                               

Provision for loan losses

     470        1,625      10,513        5,441   
                               

Net interest income after provision for loan losses

     4,914        5,359      4,680        14,942   
                               

Noninterest income

         

Total other-than-temporary impairment of securities

     (787     —        (787     —     

Portion of losses recognized in other comprehensive loss

     (704     —        (704     —     
                               

Net impairment loss recognized in earnings

     (83     —        (83     —     
                               

Service fees on deposits and other banking services

     352        326      1,101        823   

Mortgage banking (including net gains on sales of loans held for sale)

     540        —        607        —     

Net gain on sale of securities available for sale

     446        127      2,334        1,259   

Net gain (loss) on sale of other real estate owned

     (147     —        (145     (40

Other

     367        251      776        547   
                               

Total noninterest income

     1,475        704      4,590        2,589   
                               

Noninterest expense

         

Salaries and employee benefits

     4,194        3,226      11,580        9,348   

Occupancy

     682        685      2,038        2,064   

Equipment and furniture

     313        252      868        818   

Data processing

     276        161      662        511   

Professional fees

     1,338        249      2,740        831   

Customer expense

     92        121      281        369   

FDIC expense

     683        166      1,933        478   

Other real estate owned

     1,170        65      1,689        494   

Other operating expense

     764        641      2,252        2,042   
                               

Total noninterest expense

     9,512        5,566      24,043        16,955   
                               

Income (loss) before income taxes

     (3,123     497      (14,773     576   

Income tax provision (benefit)

     (1,211     143      (6,180     51   
                               

Net income (loss)

   $ (1,912   $ 354    $ (8,593   $ 525   
                               

Earnings (loss) per share

         

Basic

   $ (0.18   $ 0.03    $ (0.82   $ 0.05   

Diluted

   $ (0.18   $ 0.03    $ (0.82   $ 0.05   

Dividends paid per share

     —          —        —        $ 0.10   

Weighted average number of shares:

         

Basic

     10,434,665        10,475,471      10,434,665        10,481,558   

Diluted

     10,434,665        10,479,280      10,434,665        10,595,249   

The accompanying notes are an integral part of these consolidated financial statements.

 

2


Table of Contents

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (LOSS)

(Dollars in thousands)

(Unaudited)

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
 
     2009     2008    2009     2008  

Net income (loss)

   $ (1,912   $ 354    $ (8,593   $ 525   

Other comprehensive loss, net of tax:

         

Change in unrealized gain (loss) on securities available for sale, net of tax effect

     140        176      (506     (2,649

Change in net unrealized gain and prior service benefit on supplemental executive retirement plan, net of tax effect

     7        12      115        35   
                               

Total comprehensive (loss)

   $ (1,765   $ 542    $ (8,984   $ (2,089
                               

The accompanying notes are an integral part of these consolidated financial statements.

 

3


Table of Contents

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

 

     Nine Months Ended
September 30,
 
     2009     2008  

Cash Flows From Operating Activities:

    

Net income (loss)

   $ (8,593   $ 525   

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

    

Depreciation and amortization

     359        486   

Provision for loan losses

     10,513        5,441   

Net amortization of premium on securities

     1,104        213   

Net gains on sales of securities available for sale

     (2,334     (1,259

Mark to market loss adjustment of equity securities

     —          25   

Net gains on sales of mortgage loans held for sale

     (311     —     

Proceeds from sales of mortgage loans held for sale

     28,874        —     

Originations and purchases of mortgage loans held for sale

     (39,058     —     

Mark to market (gain) adjustment of loans held for sale

     (166     —     

Increase in current taxes receivable

     (2,662     —     

Net amortization of deferred fees and unearned income on loans

     (141     —     

Net loss on sales of other real estate owned

     145        40   

Write down of other real estate owned

     1,309        260   

Stock-based compensation expense

     252        466   

Other than temporary impairment of securities

     83        —     

Changes in operating assets and liabilities:

    

Net (increase) decrease in accrued interest receivable

     (216     364   

Net (increase) decrease in other assets and capitalized costs on other real estate owned

     (1,460     673   

Net increase in deferred taxes

     (4,763     (2,693

Net decrease in accrued interest payable

     (1,221     (706

Net increase in other liabilities

     1,650        267   
                

Net cash (used in) provided by operating activities

     (16,636     4,102   

Cash Flows From Investing Activities:

    

Net increase in interest-bearing deposits with financial institutions

     (16,602     —     

Maturities of and principal payments received for securities available for sale and other stock

     12,037        30,595   

Purchase of securities available for sale and other stock

     (136,596     (118,453

Proceeds from sale of securities available for sale and other stock

     187,681        101,838   

Proceeds from sales of other real estate owned

     3,160        943   

Net increase in loans

     (2,676     (70,897

Purchases of premises and equipment

     (549     (48
                

Net cash provided by (used in) in investing activities

     46,455        (56,022

Cash Flows From Financing Activities:

    

Net increase in deposits

     35,852        44,035   

Dividends paid

     —          (1,049

Net cash paid for share buyback

     —          (353

Net (decrease) increase in borrowings

     (81,758     39,901   
                

Net cash (used in) provided by financing activities

     (45,906     82,534   
                

Net (decrease) increase in cash and cash equivalents

     (16,087     30,614   

Cash and Cash Equivalents, beginning of period

     107,133        53,732   
                

Cash and Cash Equivalents, end of period

   $ 91,046      $ 84,346   
                

The accompanying notes are an integral part of these consolidated financial statements.

 

4


Table of Contents

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

 

     Nine Months Ended
September 30,
 
     2009     2008  

Supplementary Cash Flow Information:

    

Cash paid for interest on deposits and other borrowings

   $ 24,698      $ 26,584   
                

Cash paid for income taxes

   $ —        $ 1,520   
                

Non-Cash Investing Activities:

    

Net decrease in net unrealized losses and prior year service cost on supplemental employee retirement plan, net of tax

   $ 115      $ 35   
                

Net increase in net unrealized gains (losses) on securities held for sale, net of income tax

   $ (506   $ (2,649
                

Transfer into other real estate owned

   $ 2,756      $ 6,775   
                

Securities purchased and not settled

   $ —        $ 9,877   
                

The accompanying notes are an integral part of these consolidated financial statements.

 

5


Table of Contents

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY

(Shares and dollars in thousands)

For The Nine Months Ended September 30, 2009

 

     Common stock and paid-in
capital
   Retained
earnings
    Accumulated
other
comprehensive
income (loss)
    Total  
     Number
of shares
   Amount       

Balance at December 31, 2008

   10,435    $ 72,592    $ 12,831      $ (1,191   $ 84,232   

Cumulative effect of adoption of accounting principle(1)

   —        —        878       (878 )     —     

Stock based compensation expense

   —        252      —          —          252   

Net loss

   —        —        (8,593     —          (8,593

Change in unrealized gain on securities held for sale, net of tax

   —        —        —          372        372   

Change in unrealized expense on supplemental executive retirement plan, net of taxes

   —        —        —          115        115   
                                    

Balance at September 30, 2009

   10,435    $ 72,844    $ 5,116      $ (1,582   $ 76,378   
                                    

 

(1)

Impact on prior period of adopting ASC 320-10, Recognition and Presentation of Other-Than-Temporary-Impairments.

The accompanying notes are an integral part of this consolidated financial statement.

 

6


Table of Contents

Part I. Item 1. (continued)

PACIFIC MERCANTILE BANCORP AND SUBSIDIARIES

Notes to Consolidated Financial Statements

(Unaudited)

1. Nature of Business

Pacific Mercantile Bancorp (“PMBC”) is a bank holding company which, through its wholly owned subsidiary, Pacific Mercantile Bank (the “Bank”) is engaged in the commercial banking business in Southern California. PMBC is registered as a one bank holding company under the United States Bank Holding Company Act of 1956, as amended. The Bank is chartered by the California Department of Financial Institutions (the “DFI”) and is a member of and subject to regulation by the Federal Reserve Bank of San Francisco (“FRB”). In addition, the deposit accounts of the Bank’s customers are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to the maximum amount allowed by law. PMBC and the Bank, together, shall sometimes be referred to in this report as the “Company” or as “we”, “us” or “our”.

Substantially all of our operations are conducted and substantially all our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues and expenses, and earnings. The Bank provides a full range of banking services to small and medium-size businesses, professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego Counties of California and is subject to competition from other financial institutions and from financial services organizations conducting operations in those same markets.

During 2002, we organized three business trusts, under the names Pacific Mercantile Capital Trust I, PMB Capital Trust I, and PMB Statutory Trust III, respectively, to facilitate our issuance of $5.155 million, $5.155 million and $7.217 million, respectively, principal amount of junior subordinated debentures, all with maturity dates in 2032. In October 2004, we organized PMB Capital Trust III to facilitate our issuance of an additional $10 million principal amount of junior subordinated debentures, with a maturity date in 2034. The financial statements of these trusts are not included in the Company’s consolidated financial statements. In July 2007, we redeemed the $5.155 million principal amount of junior subordinated debentures issued in conjunction with the organization of Pacific Mercantile Capital Trust I and in August 2007, we redeemed the $5.155 million principal amount of junior subordinated debentures issued in conjunction with the organization of PMB Capital Trust I. Those trusts were dissolved as a result of those redemptions.

2. Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies

The accompanying unaudited consolidated financial statements have been prepared in accordance with the instructions to Form 10–Q and, therefore, do not include all footnotes that would be required for a full presentation of financial position, results of operations, changes in cash flows and comprehensive income (loss) in accordance with generally accepted accounting principles in the United States (“GAAP”). However, these interim financial statements reflect all adjustments (consisting of normal recurring adjustments and accruals) which, in the opinion of our management, are necessary for a fair presentation of our financial position as of the end of and our results of operations for the interim periods presented.

These unaudited consolidated financial statements have been prepared on a basis consistent with prior periods, and should be read in conjunction with our audited consolidated financial statements as of and for the year ended December 31, 2008, and the notes thereto, included in our Annual Report on Form 10–K for the year ended December 31, 2008, as filed with the Securities and Exchange Commission under the Securities Exchange Act of 1934.

Our consolidated financial position at September 30, 2009, and the consolidated results of operations for the three and nine month periods ended September 30, 2009, are not necessarily indicative of what our financial position will be as of December 31, 2009, or of the results of our operations that may be expected for the full year ending December 31, 2009.

 

7


Table of Contents

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

2. Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies (Cont.-)

Use of Estimates

The preparation of the financial statements in conformity with generally accepted accounting principles requires management to make certain estimates and assumptions that affect the reported amounts of certain of our assets, liabilities, and contingencies at the date of the financial statements and the reported amounts of our revenues and expenses during the reporting periods. For the fiscal periods covered by this Report, those estimates related primarily to our determinations of the allowance for loan losses, the fair value of securities available for sale, loans held for sale and the valuation of deferred tax assets. If circumstances or financial trends on which those estimates were based were to change in the future or there were to occur any currently unanticipated events affecting the amounts of those estimates, our future financial position or results of operations could differ, possibly materially, from those expected at the current time.

Recent Accounting Pronouncements

In September, 2009, the Financial Accounting Standards Board (“FASB”) issued an update to Accounting Standard Codification 105-10, “Generally Accepted Accounting Principles”. This standard establishes the FASB Accounting Standard Codification (“Codification”or “ASC”) as the source of authoritative U.S. Generally Accepted Accounting Principles (“GAAP”) recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC companies. The Codification supersedes all then-existing non-SEC accounting and reporting standards. This Statement is effective for financial statements issued for interim and annual periods ending after September 15, 2009. FASB Statement No. 162, The Hierarchy of Generally Accepted Accounting Principles, which became effective on November 13, 2008, identified the sources of accounting principles and the framework for selecting the principles used in preparing the financial statements in conformity with GAAP. Statement 162 arranged these sources of GAAP in a hierarchy for users to apply accordingly. The Codification, and all of its content, will carry the same level of authority, effectively superseding Statement 162. In other words, the GAAP hierarchy is modified to include only two levels of GAAP: authoritative and non-authoritative. As a result, this Statement replaces Statement 162 to indicate this change to the GAAP hierarchy.

In April, 2009, the FASB issued an update to ASC 820-10, Fair Value Measurements and Disclosures (“ASC 820-10”), which relates to the manner in which fair values are to be determined when there is no active market or where the price inputs being used represent distressed sales. It reaffirms the objective of fair value measurement—to reflect how much an asset would be sold for in an orderly transaction under current market conditions, as opposed to a distressed or forced transaction, at the date of the financial statements. Specifically, it reaffirms the need to use judgment to ascertain if a formerly active market has become inactive and to determine fair values when markets have become inactive. We adopted this guidance effective as of April 1, 2009. However, it has not had a material effect on our consolidated financial statements.

In April, 2009, the FASB issued ASC 825-10 (“ASC 825-10”), Interim Disclosures about Fair Value of Financial Instruments, which enhances consistency in financial reporting by increasing the frequency of fair value disclosures. ASC 825-10 relates to fair value disclosures for any financial instruments that are not currently reflected on the balance sheet of companies at fair value. Prior to issuing these statements, fair values for these assets and liabilities were only disclosed once a year. These statements now require disclosures on a quarterly basis, providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value. We adopted these statements April 1, 2009 with no material effect on our consolidated financial statements.

In April, 2009, the FASB issued ASC 320-10 (“ASC 320-10”), Recognition and Presentation of Other-Than-Temporary Impairments, which provides additional guidance designed to create greater clarity and consistency in accounting for and presenting impairment losses on securities. ASC 320-10 provide greater clarity to investors about the credit and noncredit components of impaired debt securities that are not expected to be sold. The measure of impairment in comprehensive income remains fair value. These statements also require increased and more timely disclosures regarding expected cash flows, credit losses, and an aging of securities with unrealized losses. We adopted these statements April 1, 2009 with no material effect on our consolidated financial statements.

In May, 2009, the FASB issued ASC 855-10 (“ASC 855-10”), which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued. In particular, this Statement sets forth; 1) the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

2. Significant Accounting Policies, Recent Accounting Pronouncements, Commitments and Contingencies (Cont.-)

disclosure in the financial statements, 2) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements, 3) the disclosures that an entity should make about events or transactions that occurred after the balance sheet date. This Statement is effective for interim or annual financial periods ending after September 15, 2009. In connection with preparing the accompanying unaudited interim consolidated financial statements as of and for the quarter and nine-month period ended September 30, 2009, management evaluated subsequent events through November 9, 2009, which is the date that such financial statements were issued (filed with the Securities and Exchange Commission).

Commitments and Contingencies

Commitments

To meet the financing needs of our customers in the normal course of business, we are a party to financial instruments with off-balance sheet risk. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated financial statements. At September 30, 2009, loan commitments and letters of credit totaled $204 million and $12 million, respectively. The contractual amount of a credit-related financial instrument such as a commitment to extend credit, a credit-card arrangement or a letter of credit represents the amounts of potential accounting loss should the commitment be fully drawn upon, the customer were to default, and the value of any existing collateral securing the customer’s payment obligation become worthless.

As a result, we use the same credit policies in making commitments to extend credit and conditional obligations as we do for on-balance sheet instruments. Commitments generally have fixed expiration dates; however, since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis, using the same credit underwriting standards that are employed in making commercial loans. The amount of collateral obtained, if any, upon an extension of credit is based on management’s credit evaluation of the customer. Collateral held varies, but may include accounts receivable, inventory, property, plant and equipment, real estate and income-producing commercial properties.

Legal Proceedings

James Laliberte, et al. vs. Pacific Mercantile Bank, filed in May 2003 in the California Superior Court for the County of Orange (Case No. 030007092). This lawsuit was initially filed as an individual action by two plaintiffs for alleged violations by the Bank of the Federal Truth in Lending Act (the “TILA”). The two plaintiffs subsequently amended their complaint on three occasions, between November 2003 and May 2005, seeking to convert their individual action into a class action suit and adding additional allegations and seeking rescission of all loans made to the members of the class and damages based on allegations of fraud in the inducement of certain loans, unfair business practices and violations of TILA. In each case, the Bank filed demurs in which the Bank asserted that the plaintiffs had failed to establish a legal basis for any recovery and in each case the trial court sustained the Bank’s demurs and dismissed the plaintiffs’ lawsuit. Plaintiffs subsequently appealed the trial court’s rulings. In January 2007, the appellate court, in a published decision, affirmed the trial court’s order dismissing the plaintiffs’ suit, finding that plaintiffs had no right to assert class-wide claims of rescission. Plaintiffs then appealed this decision to the U.S. Supreme Court which, in May 2007, denied plaintiffs’ petition for review, effectively sustaining the appellate court’s ruling.

Plaintiffs, abandoning their claims of fraud and unfair business practices on the part of the Bank, then filed a motion with the trial court for class certification limited to the TILA and certain related statutory claims. Following a hearing, in January 2008 the trial court denied the motion for class certification, finding that plaintiffs had not shown evidence that there were common questions of law or fact to justify certifying a class and had been unable to introduce any admissible evidence establishing that any statutory violations had occurred during the relevant class period. As a result of the trial court’s ruling, the two named plaintiffs were left only with individual claims for statutory damages under TILA, which would not have been material in amount.

However, in April 2008, plaintiffs filed an appeal of the trial court’s denial of their motion for class certification on the claims under TILA and certain other related statutory claims. In April 2009 the appellate court issued an order certifying plaintiff’s class action with respect to the TILA claims and remanded the case back to the trial court for further proceedings. As a result, although it has not yet done so, the trial court may set a trial date to adjudicate those claims. If the plaintiffs were to prevail in such a trial, they could recover damages of up to, but not to exceed, $500,000 and their attorneys’ fees in an amount that would be determined by the trial court.

We believe that the Bank has strong defenses to the plaintiffs’ claims and will prevail at trial. However, because the trial is likely to be heard before a jury and the outcome of jury trials is inherently uncertain, it is not possible to predict, with any certainty, the ultimate outcome of the lawsuit.

We also are subject to legal actions that arise from time to time in the ordinary course of our business. Currently there are no such pending legal proceedings that we believe will become material to our financial condition or results of operations.

3. Income (Loss) Per Share

Basic income (loss) is computed by dividing net income (loss) by the weighted average number of common shares outstanding for the period. Diluted income (loss) per share reflects the potential dilution that would occur if stock options or other contracts to issue common stock were exercised or converted into shares of common stock which would share in our earnings. For the three and nine month periods ended September 30, 2009, stock options to purchase 1,155,244 shares were not considered in computing diluted income (loss) per common share because they were antidilutive. For the three and nine month periods ended September 30, 2008, stock options to purchase 1,006,644 and 530,943 shares, respectively, were not considered in computing diluted earnings per common shares because they were antidilutive.

The following table illustrates our computation of basic and diluted income (loss) for the three and nine month periods ended September 30, 2009 and 2008.

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,

(In thousands, except earnings per share data)

   2009     2008    2009     2008

Net income (loss) available for common shareholders (A)

   $ (1,912   $ 354    $ (8,593   $ 525
                             

Weighted average outstanding shares of common stock (B)

     10,435        10,475      10,435        10,482

Dilutive effect of employee stock options and warrants

     —          4      —          113
                             

Common stock and common stock equivalents (C)

     10,435        10,479      10,435        10,595
                             

Income (loss) per share:

         

Basic (A/B)

   $ (0.18   $ 0.03    $ (0.82   $ 0.05

Diluted (A/C)

   $ (0.18   $ 0.03    $ (0.82   $ 0.05

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

4. Stock-Based Employee Compensation Plans

We have in effect three equity incentive compensation plans that provide for the grant of equity incentives to our officers, other key employees and directors: (i) a 1999 Stock Option Plan (the “1999 Plan”), which authorized the granting of options to purchase up to a total of 1,248,230 shares of our common stock (which number has been adjusted for stock splits effectuated subsequent to the Plan’s adoption), (ii) a 2004 Stock Incentive Plan (the “2004 Plan”) which set aside 400,000 shares our common stock for the grant of stock options and rights to purchase restricted stock (“restricted shares”); and (iii) a 2008 Equity Incentive Plan (the “2008 Plan”), which set aside an additional 400,000 shares of our common stock for the grant of stock options, restricted shares and stock appreciation rights (“SARs”). All three Plans have been approved by our shareholders. Options may no longer be granted under the 1999 Plan as the right to grant options under that Plan expired earlier in 2009.

Stock options entitle the recipients to purchase common stock at a price per share that may not be less than 100% of the fair market value of the Company’s shares on the respective grant dates of the stock options. Restricted shares may be granted at such purchase prices and on such other terms, including restrictions and Company repurchase rights, as are fixed by the Compensation Committee at the time rights to purchase such shares are granted. SARs entitle the recipient to receive a cash payment in an amount equal to the difference between the fair market value of the Company’s shares on the date of vesting and a “base price” (which, in most cases, will be equal to fair market value of the Company’s shares on the date of grant), subject to the right of the Company to make such payment in shares of its common stock at their then fair market value. Options, restricted shares and SARs may vest immediately or in installments over various periods generally ranging up to five years, subject to the recipient’s continued employment or service or the achievement of specified performance goals, as determined by the Compensation Committee at the time it grants the options, the rights to purchase the restricted shares or the SARs. Stock options and SARs may be granted for terms of up to 10 years after the date of grant, but will terminate sooner upon or shortly after a termination of service occurring prior to the expiration of the term of the option. The Company will become entitled to repurchase any unvested restricted shares, at the same price that was paid for the shares by the recipient, in the event of a termination of employment or service of the holder of such shares. To date, the Company has not granted any restricted shares or any SARs.

Under ASC 718-10, we (and other public companies in the United States) are required to recognize, in our financial statements, the fair value of the options or any restricted shares that we grant as compensation cost over their respective service (vesting) periods.

The fair values of the options that were outstanding under the 1999, 2004 and 2008 Plans were estimated as of their respective dates of grant using the Black-Scholes option-pricing model. For additional information regarding the Company’s stock based compensation plans, refer to Note 11—“Stock-based Compensation Plans” in the Notes to Consolidated Financial Statements included in the Company’s Form 10-K for the year ended December 31, 2008.

The following table summarizes the weighted average assumptions used for grants in the following periods:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
Assumptions with respect to:    2009     2008(1)     2009     2008(1)  

Expected volatility

     34     30     34     30

Risk-free interest rate

     2.41     3.74     2.41     3.53

Expected dividends

     0.26     0.26     0.26     0.66

Expected term (years)

     6.9        6.9        6.9        6.9   

Weighted average fair value of options granted during period

   $ 1.41      $ 1.43      $ 1.39      $ 1.84   

 

(1) The Company did not grant stock options during the first quarter of 2008.

The following tables summarize the stock option activity under the Company’s 1999, 2004 and 2008 Plans during the nine month period ended September 30, 2009 and 2008, respectively.

 

     Nine Months Ended
September 30,
     2009    2008
     Number of
Shares Subject
to Options
    Weighted-
Average
Exercise
Price
Per Share
   Number of
Shares Subject
to Options
    Weighted-
Average
Exercise
Price
Per Share

Outstanding—January 1,

   1,137,244      $ 9.31    1,133,139      $ 9.82

Granted

   58,500        3.58    17,500        7.53

Exercised

   —          —      (66,062     5.23

Forfeited/Canceled

   (40,500     10.70    (25,333     13.81
                 

Outstanding—September 30,

   1,155,244        8.97    1,059,244        9.98
                 

Options Exercisable—September 30,

   930,936      $ 9.58    911,180      $ 9.36
                 

The aggregate intrinsic values of options exercised during the nine months ended September 30, 2008 were $225,000 and there were no options exercised during the nine months ended September 30, 2009. The fair values of vested options at September 30, 2009 and 2008, were $272,645 and $482,000, respectively.

 

     Options Outstanding as of September 30, 2009    Options Exercisable as of
September 30, 2009

Range of Exercise Price

   Vested    Unvested    Weighted-
Average
Exercise
Price
   Weighted-
Average
Remaining
Contractual
Life (Years)
   Shares    Weighted-
Average
Exercise Price

$ 3.48 – $5.99

   2,295    165,705    $ 3.72    9.26    2,295    $ 3.48

$ 6.00 – $9.99

   507,301    10,000      7.32    1.21    507,301      7.33

$10.00 – $12.99

   310,600    1,000      11.23    4.38    310,600      11.22

$13.00 – $17.99

   98,140    39,203      15.07    6.09    98,140      15.05

$18.00 – $18.84

   12,600    8,400      18.12    6.32    12,600      18.12
                       
   930,936    224,308    $ 8.97    3.91    930,936    $ 9.58
                       

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

4. Stock-Based Employee Compensation Plans (Cont.-)

The aggregate intrinsic values of options that were outstanding and exercisable under the Plans at September 30, 2009, and 2008, were zero and $296,000, respectively. A summary of the status of the unvested options as of December 31, 2008, and changes during the nine month period ended September 30, 2009, are set forth in the following table.

 

     Number of
Shares Subject
to Options
    Weighted-
Average
Grant Date
Fair Value

Unvested at December 31, 2008

   233,416      $ 3.39

Granted

   58,500        1.39

Vested

   (45,808     5.39

Forfeited/Canceled

   (21,800     3.60
        

Unvested at September 30, 2009

   224,308      $ 2.43
        

The aggregate amounts charged against income in relation to stock-based compensation awards was $148,000 net of $104,000 in taxes and $274,000 net of $192,000 in taxes for the nine months ended September 30, 2009 and 2008, respectively. The weighted average period over which nonvested awards are expected to be recognized was 1.86 year at September 30, 2009. The income tax compensation expense at September 30, 2009 related to non-vested stock options is expected to be recognized in the respective amounts set forth in the table below:

 

     Stock Based
Compensation Expense
     (In thousands)

Remainder of 2009

   $ 83

For the year ending December 31,

  

2010

     194

2011

     120

2012

     61

2013

     38

2014

     4
      

Total

   $ 500
      

5. Employee Benefit Plan

The Company has established a Supplemental Retirement Plan (“SERP”) for its Chief Executive Officer. The components of net periodic benefit cost for the SERP are set forth in the table below:

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2009    2008    2009    2008
     (In thousands)

Service cost

   $ 47    $ 46    $ 140    $ 138

Interest cost

     30      28      91      80

Expected return on plan assets

     —        —        —        —  

Amortization of prior service cost

     3      4      11      11

Amortization of net actuarial loss

     7      16      30      48
                           

Net periodic SERP cost

   $ 87    $ 94    $ 272    $ 277
                           

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

6. Income Taxes

The provision for income taxes was a benefit of $1.2 million and an expense of $143,000 for the three months ended September 30, 2009 and 2008, respectively, representing effective tax rates of 39% and 29% during those periods. The provision for income taxes was a benefit of $6.2 million and an expense of $51,000 for the nine months ended September 30, 2009 and 2008, respectively, representing effective tax rates of 42% and 9% during those periods. The Company applied an estimated annual effective tax rate to the year-to-date pre-tax earnings to derive the provision for income taxes for the three and nine months ended September 30, 2009 and 2008.

We recognize deferred tax assets and liabilities for the future tax consequences related to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, and for tax credits. Our deferred tax assets, net of a valuation allowance, totaled $8.2 million and $6.6 million as of September 30, 2009 and December 31, 2008, respectively. We evaluate our deferred tax assets for recoverability using a consistent approach which considers the relative impact of negative and positive evidence, including our historical profitability and projections of future taxable income. We are required to establish a valuation allowance for deferred tax assets and record a charge to income or stockholders’ equity if we determine, based on available evidence at the time the determination is made, that it is more likely than not that some portion or all of the deferred tax assets will not be realized. In evaluating the need for a valuation allowance, we estimate future taxable income based on management-approved business plans and ongoing tax planning strategies. This process involves significant management judgment about assumptions that are subject to change from period to period based on changes in tax laws or variances between our projected operating performance, our actual results and other factors.

During the fourth quarter of 2008, we concluded that it was more likely than not that we would not generate sufficient future taxable income in the foreseeable future to realize all of our deferred tax assets. Our conclusion was based on our consideration of the relative weight of the available evidence, including the rapid deterioration of market and economic conditions, and the uncertainty of future market conditions on our results of operations. As a result, we recorded a $3.0 million valuation allowance to our deferred tax asset for the portion of the future tax benefit that more likely than not will not be utilized in the future. We did not, however, establish a valuation allowance for the deferred tax asset amount that is related to unrealized losses recorded through other comprehensive income on our available-for-sale securities. We believe this deferred tax amount is recoverable because we have the intent and ability to hold these securities until recovery of the unrealized loss amounts.

The Company files income tax returns with the U.S. federal government and the state of California. As of September 30, 2009 and January 1, 2009, we were subject to examination by the Internal Revenue Service with respect to our U.S. federal tax returns and the Franchise Tax Board for California, for the 2005 to 2007 tax years. As of September 30, 2009, the 2006 and 2007 tax years were under examination by the state of California. We do not believe there will be any material adverse changes in our unrecognized tax benefits over the next 12 months.

Net operating losses (NOL) on U.S. federal income tax returns may be carried back five years and forward twenty years. NOL on California state income tax returns maybe carried forward twenty years. The Company filed an amended prior year U.S. federal tax return and carry back the U.S. federal tax net operating loss. The state of California has suspended the net operating carryover deduction in 2008 and 2009, but corporations may continue to compute and carryover an NOL during the suspension period. Beginning in 2011, California taxpayers may carryback losses for two years and carryforward for twenty years which will conform to the U.S. tax laws by 2013. The Company expects to have taxable income in future years to offset the California NOL generated in 2008.

Our policy is to recognize interest and penalties accrued on any unrecognized tax benefits as a component of tax expense. We did not have any accrued interest or penalties associated with any unrecognized tax benefits, and no interest expense was recognized during the nine months ended September 30, 2009 and 2008. Our effective tax rate differs from the federal statutory rate primarily due to tax free income on municipal bonds and certain non-deductible expenses recognized for financial reporting purposes and state taxes.

7. Fair Value Measurements

Fair Value Hierarchy. Under ASC 820-10, we group assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. These levels are:

 

Level 1    Valuation is based upon quoted prices for identical instruments traded in active markets.
Level 2    Valuation is based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques for which all significant assumptions are observable in the market.
Level 3    Valuation is generated from model-based techniques that use at least one significant assumption not observable in the market. These unobservable assumptions reflect estimates of assumptions that market participants would use in pricing the asset or liability. Valuation techniques include use of option pricing models, discounted cash flow models and similar techniques.

The following is a description of valuation methodologies used for assets and liabilities recorded at fair value.

Assets Measured at Fair Value on a Recurring Basis

Investment Securities Available for Sale. Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 investments securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the- counter markets and money market funds. Level 2 investment securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include asset-backed securities in less liquid markets.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

7. Fair Value Measurement (Cont-)

The following table shows the recorded amounts of assets measured at fair value on a recurring basis.

 

     At September 30, 2009
(in thousands)
     Total    Level 1    Level 2    Level 3

Assets at Fair Value:

           

Investment securities available for sale

   $ 116,483    $ 2,292    $ 111,917    $ 2,274

Loans held for sale

     —        —        —        —  
                           

Total assets at fair value on a recurring basis

   $ 116,483    $ 2,292    $ 111,917    $ 2,274
                           

The changes in Level 3 assets measured at fair value on a recurring basis are summarized in the following table:

 

     Investment Securities
Available for Sale
(in thousands)
 

Balance of recurring Level 3 instruments at January 1, 2009

   $ 1,237   

Total gains or losses (realized/unrealized):

  

Included in earnings-realized

     —     

Included in earnings-unrealized (1)

     (83

Included in other comprehensive income

     306   

Purchases, sales, issuances and settlements, net

     —     

Transfers in and/or out of Level 3

     814   
        

Balance of Level 3 assets at September 30, 2009

   $ 2,274   
        

 

(1)

Amount reported as an other than temporary impairment loss in the noninterest income portion of the income statement

(2)

Amount includes one non-agency collateralized mortgage obligation security that required assessment for other than temporary impairment. See Note 8 for more details.

Assets Recorded at Fair Value on a Nonrecurring Basis

The Company may be required, from time to time, to measure certain assets at fair value on a nonrecurring basis in accordance with U.S. generally accepted accounting principles. These include assets that are measured at the lower of cost or market or that were recognized at a fair value below cost at the end of the period.

Impaired Loans. ASC 820-10 applies to loans measured for impairment in accordance with ASC 310-10, Accounting by Creditors for Impairment of a Loan, including impaired loans measured at an observable market price (if available), and at the fair value of the loan’s collateral (if the loan is collateral dependent). The fair value of an impaired loan is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance for possible losses represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the impaired loan at Level 3.

Foreclosed Assets. Foreclosed assets are adjusted to fair value, less estimated costs to sell, at the time the loans are transferred to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value less estimated costs to sell. Fair value is determined based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the foreclosed asset at Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the foreclosed asset at Level 3.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

7. Fair Value Measurements (Cont-)

Information regarding assets measured at fair value on a nonrecurring basis is set forth in the table below.

 

     At September 30, 2009
(in thousands)
     Total    Level 1    Level 2    Level 3

Assets at Fair Value:

           

Loans

   $ 61,729    $ —      $ 14,440    $ 47,289

Loans held for sale

     10,598      —        —        10,598

Other assets(1)

     13,992      —        13,992      —  
                           

Total

   $ 86,319    $ —      $ 28,432    $ 57,887
                           

 

(1)

Includes foreclosed assets

There were no transfers in or out of level 3 measurements for nonrecurring items during the nine months ended September 30, 2009.

We have elected to use fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. Securities available for sale are recorded at fair value on a recurring basis. Additionally, from time to time, we may be required to record at fair value other assets on a nonrecurring basis, such as loans held for investment and certain other assets. These nonrecurring fair value adjustments typically involve application of lower of cost or market accounting or write-downs of individual assets.

Fair value estimates are made at a discrete point in time based on relevant market information and other information about the financial instruments. Because no active market exists for a significant portion of our financial instruments, fair value estimates are based in large part on judgments we make primarily regarding current economic conditions, risk characteristics of various financial instruments, prepayment rates, and future expected loss experience. These estimates are subjective in nature and invariably involve some inherent uncertainties. Additionally unexpected changes in events or circumstances can occur that could require us to make changes to our assumptions and which, in turn, could significantly affect and require us to make changes to our previous estimates of fair value.

In addition, the fair value estimates are based on existing on and off-balance sheet financial instruments without attempting to estimate the value of existing and anticipated future customer relationships and the value of assets and liabilities that are not considered financial instruments, such as premises and equipment and other real estate owned.

The following methods and assumptions were used to estimate the fair value of financial instruments.

Cash and Cash Equivalents. The fair value of cash and cash equivalents approximates its carrying value.

Interest-Bearing Deposits with Financial Institutions. The fair values of interest-bearing deposits maturing within ninety days approximate their carrying values.

Investment Securities Available for Sale. Investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using independent pricing models or other model-based valuation techniques such as the present value of future cash flows, adjusted for the security’s credit rating, prepayment assumptions and other factors such as credit loss assumptions. Level 1 securities include those traded on an active exchange, such as the New York Stock Exchange, U.S. Treasury securities that are traded by dealers or brokers in active over-the-counter markets and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as level 3 include asset-backed securities in less liquid markets.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

7. Fair Value Measurements (Cont-)

Federal Home Loan Bank and Federal Reserve Bank Stock. The Bank is a member of the Federal Home Loan Bank (the “FHLB”) and the Federal Reserve Bank of San Francisco (the “FRB”). As members, we are required to own stock of the FHLB and the FRB, the amount of which is based primarily on the level of our borrowings from those institutions. We also have the right to acquire additional shares of stock in either or both of the FHLB and the FRB; however, to date, we have not done so. The fair values of that stock are equal to their respective carrying amounts, are classified as restricted securities and are periodically evaluated for impairment based on our assessment of the ultimate recoverability of our investments in that stock. Any cash or stock dividends paid to us on such stock are reported as income.

Loans Held for Sale. Loans held for sale are carried at the lower of cost or market value. The fair value of loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics. As such, the Company classifies loans subjected to nonrecurring fair value adjustments as Level 3. There were no fair value adjustments related to the $10.6 million of loans held for sale at September 30, 2009.

Loans. The fair value for loans with variable interest rates is the carrying amount. The fair value of fixed rate loans is derived by calculating the discounted value of future cash flows expected to be received by the various homogeneous categories of loans. All loans have been adjusted to reflect changes in credit risk.

Impaired Loans. ASC 820-10 applies to loans measured for impairment in accordance with ASC 310-10, “Accounting by Creditors for Impairment of a Loan”, including impaired loans measured at an observable market price (if available), and at the fair value of the loan’s collateral (if the loan is collateral dependent) less selling cost. The fair value of an impaired loan is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance for possible losses represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the impaired loan at nonrecurring Level 2. When an appraised value is not available, or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price or a discounted cash flow has been used to determine the fair value, we record the impaired loan at nonrecurring Level 3.

Foreclosed Assets. Foreclosed assets are adjusted to the lower of cost or fair value, less estimated costs to sell, at the time the loans are transferred to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value, less estimated costs to sell. Fair value is determined on the basis of independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or a current appraised value, we record the foreclosed asset at nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, we record the foreclosed asset at nonrecurring Level 3.

Deposits. The fair value of demand deposits, savings deposits, and money market deposits is defined as the amounts payable on demand at quarter-end. The fair value of fixed maturity certificates of deposit is estimated based on the discounted value of the future cash flows expected to be paid on the deposits.

Borrowings. The fair value of borrowings is the carrying amount for those borrowings that mature on a daily basis. The fair value of term borrowings is derived by calculating the discounted value of future cash flows expected to be paid out by the Company.

Junior subordinated debentures. The fair value of the junior subordinated debentures is defined as the carrying amount. These securities are variable rate in nature and reprice quarterly.

Commitments to Extend Credit and Standby Letters of Credit. The fair value of commitments to extend credit and standby letters of credit, are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. These fees were not material in amount either at September 30, 2009 or December 31, 2008.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

7. Fair Value Measurements (Cont-)

The following table sets forth the estimated fair values and related carrying amounts of our financial instruments as September 30, 2009 and December 31, 2008, respectively.

 

     September 30, 2009    December 31, 2008
     Carrying
Amount
   Estimated
Fair Value
   Carrying
Amount
   Estimated
Fair Value
     (Dollars in thousands)

Financial Assets:

           

Cash and cash equivalents

   $ 91,046    $ 91,046    $ 107,133    $ 107,133

Interest-bearing deposits with financial institutions

     16,800      16,800      198      198

Federal Reserve Bank and Federal Home Loan Bank stock

     13,603      13,603      13,420      13,420

Securities available for sale

     116,483      116,483      160,945      160,945

Loans held for sale

     10,598      10,598      —        —  

Loans, net

     817,652      806,840      828,041      821,339

Financial Liabilities:

           

Noninterest bearing deposits

     179,270      179,270      152,462      152,462

Interest-bearing deposits

     678,268      683,119      669,224      676,010

Borrowings

     152,000      153,805      233,758      239,514

Junior subordinated debentures

     17,527      17,527      17,527      17,527

8. Investment Securities Available For Sale

The following table summarizes the major components of securities available for sale and compares the amortized cost, estimated fair market values of, and gross unrealized gains and losses on, such securities at September 30, 2009 and December 31, 2008:

 

    September 30, 2009    December 31, 2008
  Amortized
Cost
   Gross Unrealized     Fair
Value
   Amortized
Cost
   Gross Unrealized     Fair
Value
     Gain    Loss           Gain    Loss    
  (Dollars in thousands)

Securities Available for Sale

                    

U.S. Treasury Securities

  $ 72,843    $ 133    $ —        $ 72,976    $ —      $ —      $ —        $ —  

Mortgage backed securities issued by US Agencies (1)

    12,457      65      (67     12,455      126,065      1,538      (471     127,132

Collateralized mortgage obligations (1)

    6,829      —        (43     6,786      425      4      —          429
                                                        

Total government and agencies securities

    92,129      198      (110     92,217      126,490      1,542      (471     127,561

Municipal securities

    14,180      149      (182     14,147      22,895      90      (1,523     21,462

Mortgage backed securities issued by non agency (1)

    7,704      —        (1,337     6,367      10,278      —        (1,340     8,938

Asset backed securities (2)

    2,737      —        (1,277     1,460      1,237      —        —          1,237

Mutual funds (3)

    2,292      —        —          2,292      1,747      —        —          1,747
                                                        

Total securities available for sale

  $ 119,042    $ 347    $ (2,906   $ 116,483    $ 162,647    $ 1,632    $ (3,334   $ 160,945
                                                        

 

(1)

Secured by close-end first lien 1-4 family residential mortgages.

(2)

Comprised of a security that represents an interest in a pool of trust preferred securities issued by U.S.-based banks and insurance companies

(3)

Consists of mutual fund investments in close-end first lien 1-4 family residential mortgages.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

Investment Securities Available for Sale (Cont-)

The amortized cost and estimated fair values of securities available for sale at September 30, 2009 and December 31, 2008, are shown in the table below by contractual maturities and historical prepayments based on the prior twelve months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, primarily because prepayment rates are affected by changes in conditions in the interest rate market and, therefore, future prepayment rates may differ from historical prepayment rates.

 

(Dollars in thousands)

   At September 30, 2009
Maturing in
 
   One year
or less
    Over one
year through
five years
    Over five
years through
ten years
    Over ten
Years
    Total  

Securities available for sale, amortized cost

   $ 78,069      $ 11,794      $ 7,586      $ 21,593      $ 119,042   

Securities available for sale, estimated fair value

     78,040        11,317        6,857        20,269        116,483   

Weighted average yield

     0.66     3.78     4.48     3.95     1.81

 

(Dollars in thousands)

   At December 31, 2008
Maturing in
 
   One year
or less
    Over one
year through
five years
    Over five
years through
ten years
    Over ten
Years
    Total  

Securities available for sale, amortized cost

   $ 14,666      $ 47,466      $ 33,062      $ 67,453      $ 162,647   

Securities available for sale, estimated fair value

     14,795        48,097        32,257        65,796        160,945   

Weighted average yield

     4.25     4.29     4.56     4.54     4.44

The Company recognized net gains on sales of securities available for sale of $1,354,000, net of $980,000 taxes on sale proceeds of $188 million in the nine months ended September 30, 2009 and $1,381,000, net of $965,000 of taxes on sale proceeds of $173 million, in the year ended December 31, 2008.

The table below shows, as of September 30, 2009, the gross unrealized losses and fair values of our investments, aggregated by investment category and length of time that the individual securities have been in a continuous unrealized loss position.

 

(Dollars In thousands)

   Securities With Unrealized Loss as of September 30, 2009  
   Less than 12 months     12 months or more     Total  
   Fair Value    Unrealized
Loss
    Fair Value    Unrealized
Loss
    Fair Value    Unrealized
Loss
 

US agencies and mortgage backed securities

   $ 1,630    $ (19   $ 4,163    $ (48   $ 5,793    $ (67

Collateralized mortgage obligations issued by U.S. agencies

     6,786      (43     —        —          6,786      (43

Non-agency collateralized mortgage obligations

     2,677      (78     3,690      (1,259     6,367      (1,337

Asset backed securities

     —        —          1,460      (1,277     1,460      (1,277

Municipal securities

     —        —          4,081      (182     4,081      (182
                                             

Total temporarily impaired securities

   $ 11,093    $ (140   $ 13,394    $ (2,766   $ 24,487    $ (2,906
                                             

Impairment exists when the fair value of the security is less than its cost. The company performs a quarterly assessment of its securities that have an unrealized loss to determine whether the decline in fair value of these securities below their cost is other-than-temporary.

The Company adopted ASC 321-10 effective April 1, 2009, and recognizes other-than-temporary impairment for its available-for-sale debt securities. In accordance with ASC 321-10, when there are credit losses associated with an impaired debt security and the Company does not have the intent to sell the security and it is more likely than not that it will not have to sell the security before recovery of its cost basis, the Company will separate the amount of impairment into the amount that is credit related and the amount related to non-credit factors. The credit-related impairment is recognized in net gain on sale of securities on the consolidated statements of operations. The non-credit-related impairment is recognized and reflected in Other Comprehensive Income.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

Investment Securities Available for Sale (Cont-)

Through the impairment assessment process, the company determined that the investments discussed below were other-than-temporarily impaired at September 30, 2009. The Company recorded impairment credit losses in earnings on available for sale securities of $83,000 for the three and nine month periods ended September 30, 2009.

Certain of the OTTI amounts were related to credit losses and recognized into earnings, with the remainder recognized into other comprehensive loss. The table below presents the roll-forward of other-than-temporary impairments where a portion related to other factors was recognized in other comprehensive loss for the three months ended September 30, 2009:

 

     Gross Other-
Than-
Temporary
Impairments
    Other-Than-
Temporary
Impairments
Included in Other
Comprehensive
Loss
    Net Other-Than-
Temporary
Impairments
Included in
Earnings
 
     (In thousands)  

Balance – July 1, 2009

   $ (74   $ (1,079   $ (1,153

Additions for credit losses on securities for which an OTTI was not previously recognized

     (83     (704     (787
                        

Balance – September 30, 2009

   $ (157   $ (1,783   $ (1,940
                        

Non Agency CMO

The company identified one non-agency collateralized mortgage obligation security (CUSIP 94982HAK3) that required assessment for OTTI at September 30 2009. This CMO is a “Super Senior Support” bond, which was originated in 2005 and issued by Wells Fargo, was rated AAA by Standard & Poor’s and Aa1 by Moody’s, and had a credit support of 2.5% of the total balance at issuance. As of Sept 30 2009, the security is rated AAA by Standard and Poor’s and A by Moody’s, has a book value of $1.5 million, a fair value of $813 thousand and a mark-to-market (OCI) loss of $704 thousand. The principal collateral of this security is a pool of one-to-four family, fully amortizing residential first mortgage loans that have a fixed payment for approximately five years after which they become a variable rate loan with annual resets. Credit support at September 30 was approximately 5.13%, however, delinquencies 60 days and over were approximately 4.3%. Factors considered in the impairment include the rating change of the security, the current level of subordination from other CMO classes, anticipated prepayment rates, cumulative default rates and the loss severity given a default. The company recognized an $83,000 impairment loss, representing a credit loss, in earnings. The remaining loss on the security was recognized through other comprehensive income. This non credit portion of OTTI is attributed to external market conditions, primarily the lack of liquidity in these securities and risks of additional declines in the housing market.

Asset Backed Securities

The Company has one asset backed security in its investment securities available for sale portfolio. The security is a multi-class, cash flow collateralized bond obligation backed by a pool of trust preferred securities issued by a diversified pool of 56 issuers consisting of 45 U.S. depository institutions and eleven insurance companies at the time of issuance in November 2007. The total size of this security at issuance was $363 million. The security that the Company owns (CUSIP 74042CAE8) is the mezzanine class B piece that floats with 3 month libor +60 basis points and had a rating of Aa2/AA by Moody’s and Fitch at the time of issuance. The Company purchased $3.0 million face value at a price of 95.21 for $2,856,420 in November 2007.

As of September 30, the book value of this security was $2.7 million with a fair value at $1.5 million for an approximate unrealized loss of $1.2 million. Currently, the security has a Caa1 rating from Moody’s and BB rating from Fitch and has experienced $15 million in defaults (4.2% of total current collateral) and $33 million in deferrals (9.2% of total current collateral) from issuance to September 30 2009. The Company estimates that there is approximately $16.5 million in potential deferrals and defaults (approximately 5% of performing collateral) before a temporary interest shortfall and $97.5 million before the Company would not receive all of its contractual cash flows. This analysis took into account future default rates of 3.3%, prepayment rates of 1% until maturity, and 15% recovery of future defaults. The Company has not recognized any additional impairment to this asset back security in the nine months ended September 30, 2009.

 

Impairment Losses on OTTI Securities

   For the three months ended
September 30
   For the nine months ended
September 30
     (Dollars in thousands)
     2009     2008    2009     2008

Non Agency CMO

     (83     —        (83     —  
                             
   $ (83   $ —      $ (83   $ —  
                             

As a part of the Company’s OTTI assessment, management considers information available about the performance of the underlying collateral, including credit enhancements, default rates, loss severities, delinquency rates, vintage, as well as rating agency reports and historical prepayment speeds. As a result, significant judgment is used in the Company’s analysis to determine the expected cash flows for its impaired securities. In determining the component of the OTTI related to credit losses, the Company compares the amortized cost basis of each other-than-temporarily impaired security to the present value of its expected cash flows, discounted using its effective interest rate implicit in the security at the date of acquisition.

The Company’s assessment that it has the ability to continue to hold impaired investment securities along with its evaluation of their future performance, as indicated by the criteria discussed above, provide the basis for it to conclude that the remainder of its impaired securities are not other-than-temporarily impaired. In assessing whether it is more likely than not that the Company will be required to sell any impaired security before its anticipated recovery, which may be at their maturity, it considers the significance of each investment, the amount of impairment, as well as the Company’s liquidity position and the impact on the Company’s capital position. As a result of its analyses, the Company determined at September 30, 2009 that the unrealized losses on its securities portfolio on which impairments have not been recognized are temporary.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Cont.-)

9. Loans

The composition of the Company’s loan portfolio as of September 30, 2009 and December 31, 2008 is as follows:

 

     September 30, 2009     December 31, 2008  
     Amount     Percent     Amount     Percent  

Commercial loans

   $ 292,757      35.1   $ 300,945      35.7

Commercial real estate loans - owner occupied

     181,135      21.7     174,169      20.6

Commercial real estate loans - all other

     131,351      15.7     127,528      15.1

Residential mortgage loans - multi-family

     103,690      12.4     100,971      12.0

Residential mortgage loans - single family

     63,616      7.6     65,127      7.7

Construction loans

     22,880      2.7     32,528      3.9

Land development loans

     31,607      3.8     33,283      3.9

Consumer loans

     8,164      1.0     9,173      1.1
                            

Gross loans

     835,200      100.0     843,724      100.0
                      

Deferred fee (income) costs, net

     (368       (230  

Allowance for loan losses

     (17,180       (15,453  
                    

Loans, net

   $ 817,652        $ 828,041     
                    

Changes in the allowance for loan losses for the nine months ended September 30, 2009 and the year ended December 31, 2008 are as follows:

 

     Nine Months Ended
September 30, 2009
    Year Ended
December 31, 2008
 

Balance, beginning of period

   $ 15,453      $ 6,126   

Provision for loan losses

     10,513        21,685   

Recoveries on loans previously charged off

     116        80   

Net, amounts charged off

     (8,902     (12,438
                

Balance, end of period

   $ 17,180      $ 15,453   
                

As of September 30, 2009, the Company had approximately $62.0 million of loans deemed impaired of which $59.6 million was nonaccrual, $22.3 million of troubled debt restructurings which was comprised of $19.8 million in nonaccrual loans and $2.4 million accruing loans performing in accordance to the modified terms, and $10.9 million of other impaired loans less than 90 days delinquent. As of December 31, 2008, the Company had $30.7 million of loans deemed impaired of which $11 million was nonaccrual, $7.5 million of troubled debt restructurings which was comprised of $4.9 million in nonaccrual loans and $2.6 million accruing loans performing in accordance to the modified terms, and $12.3 million of loans less than 90 days delinquent.

 

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Table of Contents
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Introduction

Pacific Mercantile Bancorp is a bank holding company that owns all of the stock of Pacific Mercantile Bank (the “Bank”), which is a commercial bank that provides a full range of banking services to small and medium-size businesses and to professionals and the general public in Orange, Los Angeles, San Bernardino and San Diego counties, in Southern California. Substantially all of our operations are conducted and substantially all of our assets are owned by the Bank, which accounts for substantially all of our consolidated revenues, expenses and operating income.

The following discussion presents information about (i) our consolidated results of operations for the three and nine month periods ended September 30, 2009 and comparisons of those results with the results of operations for the corresponding three and nine month periods of 2008, and (ii) our consolidated financial condition, liquidity and capital resources at September 30, 2009. The information in the following discussion should be read in conjunction with our interim consolidated financial statements and the notes thereto included elsewhere in this Report.

Forward-Looking Information

Statements contained in this Report that are not historical facts or that discuss our expectations, beliefs or views regarding our future operations or future financial performance, or financial or other trends in our business or in the markets in which we operate, 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. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. Often, they include words such as “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate,” “project,” “forecast” or words of similar meaning, or future or conditional verbs such as “will,” “would,” “should,” “could,” or “may.” The information contained in such forward-looking statements is based on current information and on assumptions that we make about future events over which we do not have control. In addition, our business and the markets in which we operate are subject to a number of risks and uncertainties. Unexpected future events and such risks and uncertainties could cause our financial condition or actual operating results in the future to differ significantly from our expected financial condition or operating results that are set forth in the forward looking statements contained in this Report and could, therefore, also affect the price performance of our shares. Certain of those risks and uncertainties are discussed below in this Item 2 of this Report, in Item 1A in our Annual Report on Form 10-K for our fiscal year ended December 31, 2008 (our “2008 10-K”) and in Item 1A, entitled “Risk Factors,” in Part II of this Report. Therefore, you are urged to read not only the information contained in this section of this Report, but also the information contained in Item 1A of our 2008 10-K and in Item 1A in Part II of this Report in conjunction with your review of the following discussion regarding our results of operations for the three and nine months ended, and our financial condition at, September 30, 2009.

Due to those risks and uncertainties, readers are cautioned not to place undue reliance on the forward-looking statements contained in this Report, which speak only as of the date of this Report, or to make predictions about future performance based solely on historical financial performance. We also disclaim any obligation to update forward-looking statements contained in this Report or in our 2008 10-K or any other of our filings previously made with Securities and Exchange Commission, except as may otherwise be required by law or Nasdaq rules.

 

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Table of Contents

Overview of Operating Results in the Three and Nine Months Ended September 30, 2009

The following table sets forth information regarding the interest income that we generated, the interest expense that we incurred, our net interest income, noninterest income, noninterest expense, and our net income (loss) and net income (loss) per share for the three and nine month periods set forth below.

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009
Amounts
    2008
Amounts
   Percent
Change
    2009
Amounts
    2008
Amounts
   Percent
Change
 

Interest income

   $ 12,879      $ 15,230    (15.4 )%    $ 38,814      $ 46,262    (16.1 )% 

Interest expense

     7,495        8,246    (9.1 )%      23,621        25,879    (8.7 )% 
                                  

Net interest income

     5,384        6,984    (22.9 )%      15,193        20,383    (25.5 )% 
                                  

Provision for loan losses

     470        1,625    (71.1 )%      10,513        5,441    93.2
                                  

Net interest income (loss) after provision for loan losses

     4,914        5,359    (8.3 )%      4,680        14,942    (68.7 )% 

Noninterest income

     1,475        704    109.5     4,590        2,589    77.3

Noninterest expense

     9,512        5,566    70.9     24,043        16,955    41.8
                                  

Income (loss) before income tax

     (3,123     497    (728.4 )%      (14,773     576    N/M   

Income tax (benefit) provision

     (1,211     143    N/M        (6,180     51    N/M   
                                  

Net income (loss)

   $ (1,912   $ 354    (640.1 )%    $ (8,593   $ 525    N/M   

Net income (loss) per diluted share

   $ (0.18   $ 0.03    (700.0 )%    $ (0.82   $ 0.05    N/M   

Weighted average number of diluted shares

     10,434,665        10,479,280    (0.4 )%      10,434,665        10,595,249    (1.5 )% 

We incurred net losses of $1.9 million, or $0.18 per diluted share, and $8.6 million, or $0.82 per diluted share, in the three and nine month periods ended September 30, 2009, respectively, as compared to net income of $354,000, or $0.03 per diluted share, and $525,000, or $0.05 per diluted share, in the same three and nine month periods of 2008, respectively. The net losses in the three and nine months ended September 30, 2009 were primarily attributable to:

 

   

Declines in net interest income of $1.6 million, or 22.9%, and $5.2 million, or 25.5%, respectively, in the three and nine month periods ended September 30, 2009, due primarily to decreases in interest income that were only partially offset by decreases in interest expense, as interest income was adversely affected by (i) reductions in interest rates implemented by the Federal Reserve Board which affected the yields we were able to realize on loans and other interest-earning assets, and (ii) an increase, during the nine months ended September 30, 2009, of $37.3 million, or 234%, in non-performing loans, on which we were required to cease accruing interest.

 

   

An increase, during the nine months ended September 30, 2009, in the provisions we made for loan losses of $5.1 million, or 93%, to provide for (i) the increases that occurred in non-performing loans during that period and the risk of possible increases in non-performing loans in future months due to the continuing economic recession and credit crisis and the prospect that these conditions will not improve significantly during the remainder of 2009. These increases in the provision for loan losses resulted in an increase in the amount of our allowance for loan losses to $17.2 million, or approximately 2.06% of loans outstanding, at September 30, 2009, as compared to $15.5 million, or 1.83%, of the loans outstanding at December 31, 2008.

 

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Table of Contents
   

Increases in noninterest expense of $3.9 million, or 70.9%, and $7.1 million, or 41.8%, in the three and nine months ended September 30, 2009, respectively, due primarily to (i) the addition of personnel in our credit administration department and for our new mortgage banking business which commenced operations during the second quarter 2009, (ii) increases in expenses incurred in connection with the collection and foreclosures of non-performing loans and the carrying costs of the properties acquired by foreclosure (“Other Real Estate Owned” or “OREO”), and (iii) an increase by the FDIC in insurance premiums imposed on all FDIC-insured banks as a means of funding increases in the FDIC’s insurance fund.

We believe that our actions in charging off nonperforming loans and increasing the allowance for loan losses were prudent in light of prevailing economic conditions and the uncertainties regarding the ultimate duration and severity of the economic recession and credit crisis.

The following table indicates the impact that the decreases in our net interest income and the net losses incurred in the three and nine months ended September 30, 2009 have had on our net interest margin and the returns on average assets and average equity during those periods:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  

Net interest margin (1) (2)

   1.88   2.56   1.76   2.52

Return on average assets (1)

   (0.64 )%    0.13   (0.96 )%    0.06

Return on average shareholders’ equity (1)

   (9.82 )%    1.51   (13.58 )%    0.74

 

(1) Annualized.
(2) Net interest income expressed as a percentage of total average interest earning assets.

At September 30, 2009, non-performing loans, together with other nonperforming assets consisting of OREO, totaled $74 million, or 6.7% of total assets, as compared to $29.9 million or 2.6% of total assets at December 31, 2008.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) and general practices in the banking industry. Certain of those accounting policies are considered critical accounting policies, because they require us to make assumptions and judgments regarding circumstances or trends that could affect the value of those assets, such as, for example, assumptions regarding economic conditions or trends that could impact our ability to fully collect our loans or ultimately realize the carrying value of certain of our other assets, such as securities available for sale and our deferred tax assets. Those assumptions and judgments are made based on current information available to us regarding those economic conditions or trends or other circumstances. If adverse changes were to occur in the events, trends or other circumstances on which our assumptions or judgments had been based, or other unanticipated events were to happen that might affect our operating results, under GAAP it could become necessary for us to reduce the carrying values of the affected assets on our balance sheet. In addition, because reductions in the carrying value of assets are sometime effectuated by or require charges to income, such reductions also may have the effect of reducing our income.

For additional information regarding critical accounting policies, refer to Note 2—“Significant Accounting Policies” in the Notes to Consolidated Financial Statements and the sections captioned “Critical Accounting Policies” and “Allowance for Loan Losses” in Management’s Discussion and Analysis of Financial Condition and Results of Operations included in the Company’s Form 10-K for the year ended December 31, 2008. There have been no significant changes in the Company’s application of accounting policies since December 31, 2008.

Results of Operations

Net Interest Income

One of the principal determinants of a bank’s income is its net interest income, which is the difference between (i) the interest that a bank earns on loans, investment securities and other interest-earning assets, on the one hand, and (ii) its interest expense, which consists primarily of the interest it must pay to attract and retain deposits and the interest that it pays on borrowings and other interest-bearing liabilities, on the other hand. As a general rule, all other things being equal, the greater

 

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the difference or “spread” between the amount of our interest income and the amount of our interest expense, the greater will be our net income; whereas, a decline in that difference or “spread” will generally result in a decline in our net income. A bank’s interest income and interest expense are, in turn, affected by a number of factors, some of which are outside of its control, including national and local economic conditions and the monetary policies of the Federal Reserve Board which affect interest rates, competition in the market place for loans or deposits, the demand for loans and the ability of borrowers to meet their loan payment obligations. Net interest income, when expressed as a percentage of total average interest earning assets, is a banking organization’s “net interest margin.”

The following table sets forth our interest income, interest expense and net interest income (in thousands of dollars) and our net interest margin in the three and nine months ended September 30, 2009 and 2008, respectively:

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009
Amount
    2008
Amount
    Percent
Change
    2009
Amount
    2008
Amount
    Percent
Change
 

Interest income

   $ 12,879      $ 15,230      (15.4 )%    $ 38,814      $ 46,262      (16.1 )% 

Interest expense

     7,495        8,246      (9.1 )%      23,621        25,879      (8.7 )% 
                                    

Net interest income

   $ 5,384      $ 6,984      (22.9 )%    $ 15,193      $ 20,383      (25.5 )% 
                                    

Net interest margin

     1.88     2.56       1.76     2.52  

As the above table indicates, our net interest income decreased by $1.6 million, or 23%, in the third quarter of 2009, and by $5.2 million, or 26%, in the nine months ended September 30, 2009. The decreases were primarily attributable to decreases in interest income of $2.4 million, or 15%, and $7.4 million, or 16%, respectively, in those three and nine month periods, which more than offset decreases in interest expense of $751,000, or 9%, and $2.3 million, or about 9%, respectively, in the three and nine months ended September 30, 2009.

Those decreases in interest income were due primarily to (i) declines of 500 basis points in prevailing market rates of interest primarily as a result of reductions, commenced in September 2007, in the federal funds rate implemented by the Federal Reserve Board in response initially to a slowing in economic growth and, then, to the economic recession and credit crisis, and (ii) the increases, described above, in non-performing loans, on which we ceased accruing interest income. Those decreases were only partially offset by the effects on interest income of increases, in the three and nine months ended September 30, 2009, of $29 million and $48 million, respectively, in average loans outstanding, which generate higher yields than other interest earning assets.

The decreases in interest expense during the three and nine month periods ended September 30, 2009 were primarily attributable to the aforementioned decreases in prevailing market rates of interest, which enabled us to reduce the rates at which we paid interest on substantially all types of interest bearing deposits, including certificates of deposit. However, those decreases in interest expense were partially offset by increases, during the three and nine months ended September 30, 2009, in the volume of certificates of deposit, on which we pay interest at higher rates than on other types of deposits, as we used those deposits to provide additional funds that enabled us to increase the volume of the loans we made and to reduce borrowings during the three and nine months ended September 30, 2009.

Primarily as a result of the decreases in interest income in the three and nine months ended September 30, 2009, our net interest margin declined to 1.88% and 1.76%, respectively, from 2.56% and 2.52% in the same three and nine month periods of 2008. In the three months ended September 30, 2009, the yield on interest-earning assets declined to 4.49% from 5.61% in the same three months of 2008, which more than offset a decline in the average interest rate paid on interest bearing liabilities to 3.24%, from 3.90% in the same three month period of 2008. Similarly, in the nine months ended September 30, 2009, the average rate of interest earned on average earning assets declined to 4.48%, from 5.73% in the same nine months of 2008, and was only partially offset by a decrease in the average interest rate paid on interest bearing liabilities to 3.35%, from 4.11% in the same period of 2008. The decreases in net interest margin also reflect timing differences in the impact that the declines in market rates of interest have on our interest income and interest expense. Those declines resulted in automatic decreases in the interest rates on our adjustable rate loans, whereas the impact of those declines on the interest we paid on deposits was more gradual primarily as a result of the maturity schedule of our time certificates of deposit.

 

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Average Balances

Information Regarding Average Assets and Average Liabilities

The following table sets forth information regarding our average balance sheet, yields on interest earning assets, interest expense on interest-bearing liabilities, the interest rate spread and the interest rate margin for the three months ended September 30, 2009 and 2008.

 

     Three Months Ended
September 30,
 
     2009     2008  
     Average
Balance
   Interest
Earned/
Paid
   Average
Yield/
Rate
    Average
Balance
   Interest
Earned/
Paid
   Average
Yield/
Rate
 
     (Dollars in thousands)  

Interest earning assets:

  

Short-term investments(1)

   $ 148,568    $ 129    0.34   $ 38,526    $ 179    1.85

Securities available for sale and stock(2)

     147,764      814    2.19     228,814      2,595    4.51

Loans

     842,031      11,936    5.62     813,514      12,456    6.09
                                

Total earning assets

     1,138,363      12,879    4.49     1,080,854      15,230    5.61

Noninterest earning assets

     48,977           35,681      
                        

Total Assets

   $ 1,187,340         $ 1,116,535      
                        

Interest-bearing liabilities:

                

Interest-bearing checking accounts

   $ 26,952      58    0.85   $ 20,100      27    0.54

Money market and savings accounts

     113,350      348    1.22     117,818      511    1.72

Certificates of deposit

     604,184      5,295    3.48     450,079      4,969    4.39

Other borrowings

     163,164      1,648    4.01     239,835      2,499    4.15

Junior subordinated debentures

     17,682      146    3.28     17,682      240    5.40
                                

Total interest-bearing liabilities

     925,332      7,495    3.24     845,514      8,246    3.90
                        

Noninterest-bearing liabilities

     184,753           178,177      
                        

Total Liabilities

     1,110,085           1,023,691      

Shareholders’ equity

     77,255           92,844      
                        

Total Liabilities and Shareholders’ Equity

   $ 1,187,340         $ 1,116,535      
                        

Net interest income

      $ 5,384         $ 6,984   
                        

Interest rate spread

         1.25         1.71
                        

Net interest margin

         1.88         2.56
                        

 

(1) Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions.
(2) Stock consists of Federal Home Loan Bank Stock and Federal Reserve Bank Stock.

 

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The following table sets forth information regarding our average balance sheet, yields on interest earning assets, interest expense on interest-bearing liabilities, the interest rate spread and the interest rate margin for the nine months ended September 30, 2009 and 2008.

 

     Nine Months Ended
September 30,
 
     2009     2008  
     Average
Balance
   Interest
Earned/
Paid
   Average
Yield/
Rate
    Average
Balance
   Interest
Earned/
Paid
   Average
Yield/
Rate
 
     (Dollars in thousands)  

Interest earning assets:

  

Short-term investments(1)

   $ 163,971    $ 373    0.30   $ 47,923    $ 803    2.24

Securities available for sale and stock(2)

     147,791      2,912    2.63     233,609      7,877    4.50

Loans

     845,363      35,529    5.62     796,929      37,582    6.30
                                

Total earning assets

     1,157,125      38,814    4.48     1,078,461      46,262    5.73

Noninterest earning assets

     38,601           33,004      
                        

Total Assets

   $ 1,195,726         $ 1,111,465      
                        

Interest-bearing liabilities:

                

Interest-bearing checking accounts

   $ 26,036      118    0.61   $ 19,555      81    0.56

Money market and savings accounts

     105,473      934    1.18     140,495      2,230    2.12

Certificates of deposit

     604,152      16,647    3.68     431,661      15,148    4.69

Other borrowings

     187,296      5,425    3.87     229,607      7,633    4.44

Junior subordinated debentures

     17,682      497    3.75     17,682      787    5.95
                                

Total interest-bearing liabilities

     940,639      23,621    3.35     839,000      25,879    4.11
                        

Noninterest-bearing liabilities

     170,509           177,177      
                        

Total Liabilities

     1,111,148           1,016,177      

Shareholders’ equity

     84,578           95,288      
                        

Total Liabilities and Shareholders’ Equity

   $ 1,195,726         $ 1,111,465      
                        

Net interest income

   $ 15,193         $ 20,383   
                            

Interest rate spread

      1.13         1.62
                        

Net interest margin

      1.76         2.52
                        

 

(1) Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions.
(2) Stock consists of Federal Home Loan Bank Stock and Federal Reserve Bank Stock.

 

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The following table sets forth the changes in interest income, including loan fees, and interest paid in the three and nine months ended September 30, 2009, as compared to the same respective periods of 2008, and the extent to which those changes were attributable to changes in (i) the volumes of or in the rates of interest earned on interest-earning assets and (ii) the volumes of or the rates of interest paid on our interest-bearing liabilities.

 

     Three Months Ended
September 30,
2009 vs. 2008
Increase (decrease) due to:
    Nine Months Ended
September 30,
2009 vs. 2008
Increase (decrease) due to:
 
     Volume(1)     Rate(1)     Total     Volume(1)     Rate(1)     Total  
     (Dollars in thousands)  

Interest income:

            

Short-term investments(1)

   $ 189      $ (239   $ (50   $ 705      $ (1,135   $ (430

Securities available for sale and stock(2)

     (725     (1,056     (1,781     (2,331     (2,634     (4,965

Loans

     437        (957     (520     2,181        (4,234     (2,053
                                                

Total earning assets

     (99     (2,252     (2,351     555        (8,003     (7,448

Interest expense:

            

Interest-bearing checking accounts

     12        19        31        29        8        37   

Money market and savings accounts

     (19     (144     (163     (468     (828     (1,296

Certificates of deposit

     1,494        (1,169     325        5,195        (3,696     1,499   

Borrowings

     (771     (80     (851     (1,303     (905     (2,208

Junior subordinated debentures

     —          (93     (93     —          (290     (290
                                                

Total interest-bearing liabilities

     716        (1,467     (751     3,453        (5,711     (2,258
                                                

Net interest income

   $ (815   $ (785   $ (1,600   $ (2,898   $ (2,292   $ (5,190
                                                

 

(1) Short-term investments consist of federal funds sold and interest bearing deposits with financial institutions.
(2) Stock consists of Federal Home Loan Bank Stock and Federal Reserve Bank Stock.

The above table indicates that the decreases in our net interest income of $1.6 million and $5.2 million in the three and nine months ended September 30, 2009, respectively, were primarily attributable to decreases in rate variances of $785,000 and $2.3 million, respectively, and in volume variances of $815,000 million and $2.9 million, respectively, in the three and nine months ended September 30, 2009. Those decreases in volume variance were primarily the result of (i) decreases in the volume of securities available for sale and increases in the volume of loans, and (ii) changes in the mix of our deposits to a greater proportion of higher-cost certificates of deposit, as compared to lower-cost transaction savings and money market deposits. The declines in rate variances were a result of decreases in interest rates on average earning assets of 112 basis points and 125 basis points, respectively, which was only partially offset by decreases in interest rates paid on interest bearing liabilities of 66 basis points and 76 basis points, respectively, in the three and nine months ended September 30, 2009.

Provision for Loan Losses

The failure of borrowers to repay their loans is an inherent risk of the banking business. Therefore, like virtually all banks and other lending institutions, we follow the practice of maintaining an allowance for loan losses that occur from time to time as an incidental part of the banking business. When it is determined that the payment in full of a loan has become unlikely, the carrying value of the loan is reduced to what management believes is its realizable value. This reduction, which is referred to as a loan “charge-off,” or “write-down” is charged against that allowance.

The amount of the allowance for loan losses is increased periodically (i) to replenish the allowance after it has been reduced due to loan charge-offs, (ii) to reflect changes in the volume of outstanding loans, and (iii) to take account of increases in the risk of potential future losses due to a deterioration in the condition of borrowers or in the value of property securing non–performing loans or adverse changes in economic conditions. Increases in the allowance are made through a charge, recorded as an expense in the statement of operations, referred to as the “provision for loan losses.” Recoveries of loans previously charged-off are added back to the allowance and, therefore, have the effect of increasing the allowance and reducing the amount of the provision that might otherwise have had to be made to replenish or increase the allowance. See “—Financial Condition—Allowance for Loan Losses and Nonperforming Loans” below in this Section of this Report.

 

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During the three and nine months ended September 30, 2009, we made provisions of $470,000 and $10.5 million, respectively, for potential loan losses, as compared to $1.6 million and $5.4 million, respectively, in the respective corresponding periods of 2008. Those increases were made (i) to replenish the allowance for loan losses following net loan charge-offs of $3.8 million and $8.9 million, respectively, during those three and nine month periods of 2009, and (ii) to increase the allowance for loan losses to provide for the increase that occurred in non-accrual loans during the first nine months of 2009, and increases that we believe may occur in the foreseeable future. Nonaccrual loans increased to $59.6 million at September 30, 2009, as compared to $6.3 million at September 30, 2008, as a result of the continuing economic recession and credit crisis.

We employ economic models that are based on bank regulatory guidelines, industry standards and historical loss experience to evaluate and make judgments regarding the sufficiency of the allowance for loan losses and the amount of the provisions that are required to be made for potential loan losses. Those judgments are based on our assessments and assumptions about trends in current economic conditions and other events that can affect the ability of borrowers to meet their loan obligations to us. The duration and effects of current economic trends or conditions, such as the current economic recession, are subject to a number of risks and uncertainties and changes that are outside of our ability to control. See the discussion above under the caption “Critical Accounting Policies—Allowance for Loan Losses.” If economic or market conditions were to worsen or unexpected subsequent events were to occur, it could become necessary for us to make additional provisions to increase the allowance for loan losses, which would have the effect of reducing our income.

In addition, the Federal Reserve Bank of San Francisco and the California Department of Financial Institutions, as an integral part of their examination processes, periodically review the adequacy of our allowance for loan losses. These bank regulatory agencies may require us to make additional provisions, over and above the provisions that we have already made, the effect of which would be to further reduce our income.

Noninterest Income

Noninterest income consists primarily of fees charged for services provided by the Bank on deposit account transactions and gains on sales of assets and, during the current fiscal year, income from the origination and sale of residential mortgages. The following table identifies the amounts (in thousands of dollars) of, and sets forth the percentage changes in, the components of noninterest income in the three and nine months ended September 30, 2009, as compared to the same respective periods of 2008.

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     Amount    Percentage
Change
2009 vs. 2008
    Amount     Percentage
Change
2009 vs. 2008
 
     2009     2008      2009     2008    

Service fees on deposits

   $ 352      $ 326    8.0   $ 1,101      $ 823      33.8

Mortgage banking income (including net gains on sales of loans held for sale)

     540        —      N/M        607        —        N/M   

Net gains on sales of securities available for sale

     446        127    251.2     2,334        1,259      85.4

Net gain (loss) on sale of other real estate owned

     (147     —      N/M        (145     (40   (262.5 )% 

Other

     284        251    13.1     693        547      26.7
                                           

Total Noninterest Income

   $ 1,475      $ 704    109.5   $ 4,590      $ 2,589      77.3
                                           

As the table above indicates, the increase in noninterest income in the three months ended September 30, 2009, as compared to the same period in 2008, were primarily attributable to (i) $540,000 of income generated by our new mortgage banking division which commenced its operations during the second quarter 2009, and (ii) a $319,000 or 251% increase in net gains on sales of securities available for sale partially offset by a $147,000 loss on sale of other real estate owned. The increase in noninterest income in the nine months ended September 30, 2009, as compared to the same period in 2008, was primarily the result of a $278,000 increase in service charges on deposit account transactions, $607,000 of income generated by our new mortgage banking division, and $1.1 million increase in gains on sales of securities available for sale the proceeds from which were used to repay borrowings and, to a lesser extent, fund new loans.

 

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Noninterest Expense

The following table compares the amounts (in thousands of dollars) of the principal components of noninterest expense in the three and nine month periods ended September 30, 2009 and September 30, 2008.

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     Amount    Percentage
Change
2009 vs. 2008
    Amount    Percentage
Change
2009 vs. 2008
 
     2009    2008      2009    2008   
     (Dollars in thousands)  

Salaries and employee benefits

   $ 4,194    $ 3,226    30.0   $ 11,580    $ 9,348    23.9

Occupancy

     682      685    (0.4 )%      2,038      2,064    (1.3 )% 

Equipment and depreciation

     313      252    24.2     868      818    6.1

Data processing

     276      161    71.4     662      511    29.5

Professional fees

     1,338      249    437.3     2,740      831    229.7

Customer expense

     92      121    (24.0 )%      281      369    (23.8 )% 

FDIC insurance

     683      166    311.4     1,933      478    304.4

Other real estate owned

     1,170      65    N/M        1,689      494    241.9

Other operating expense(1)

     764      641    19.2     2,252      2,042    10.3
                                        

Total

   $ 9,512    $ 5,566    70.9   $ 24,043    $ 16,955    41.8
                                        

 

(1) Other operating expenses primarily consist of telephone, stationery and office supplies, regulatory expenses, investor relations expenses, insurance premiums, postage and correspondent banking fees.

For the three and nine months ended September 30, 2009, noninterest expenses increased by $3.9 million, or 71%, and by $7.1 million, or 42%, respectively, compared to the three and nine months ended September 30, 2008. Those increases were due primarily to increases in the three and nine months ended September 30, 2009 of (i) $968,000, or 30%, and $2.2 million, or 24%, respectively, in employee compensation expense due primarily to the addition of personnel in our credit administration department and personnel for our new mortgage banking business which commenced operations during the second quarter 2009, (ii) $1.1 million, or 437%, and $1.9 million, or 230%, respectively, in professional fees incurred in connection with the collection and foreclosures of non-performing loans and in the carrying costs of the properties acquired by foreclosure (“OREO properties”), (iii) $517,000, or 311%, and $1.5 million, or 304%, respectively, in FDIC insurance premiums imposed on all FDIC-insured banks to offset losses to the FDIC’s insurance fund as a result of the significant increase in bank failures that have occurred in the past 12 months, and (iv) $1.1 million, and $1.2 million respectively, of additional write downs in the carrying values of OREO properties based upon recent third party appraisals of those properties.

Due to the combined effects of the declines in net interest income and the increases in non-interest expense, our efficiency ratios (the ratio of non-interest expense to the sum of net interest income and noninterest income) were 139% and 122% in the three and nine months ended September 30, 2009, respectively, as compared to 72% and 74% for the corresponding three and nine month periods of 2008.

Income Tax Provision (Benefit)

We recorded income tax benefits of $1.2 million and $6.2 million for the three and nine months ended September 30, 2009, respectively, as compared to income tax expense of $143,000 and $51,000, respectively, in the respective corresponding periods of 2008. The income tax benefits were due primarily to the pre-tax losses incurred in the three and nine months ended September 30, 2009.

Asset/Liability Management

The primary objective of asset/liability management is to reduce our exposure to interest rate fluctuations, which can affect our net interest margins and, therefore, our net interest income and net earnings. We seek to achieve this objective by matching interest rate sensitive assets and liabilities, and maintaining the maturities of and repricing these assets and liabilities in response to the changes in the interest rate environment. Generally, if rate sensitive assets exceed rate sensitive liabilities, net interest income will be positively impacted during a rising interest rate environment and negatively impacted during a declining interest rate environment. When rate sensitive liabilities exceed rate sensitive assets, net interest income generally will be positively impacted during a declining interest rate environment and negatively impacted during a rising interest rate environment. However, interest rates for different asset and liability products offered by depository institutions

 

28


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respond differently to changes in the interest rate environment. As a result, the relationship or “gap” between interest sensitive assets and interest sensitive liabilities is only a general indicator of interest rate sensitivity and how our net interest income might be affected by changing rates of interest.

For example, rates on certain assets or liabilities typically lag behind changes in market rates of interest. Additionally, prepayments of loans and securities available for sale, and early withdrawals of certificates of deposit, can cause the interest sensitivities to vary.

The table below sets forth information concerning our rate sensitive assets and liabilities at September 30, 2009. The assets and liabilities are classified by the earlier of maturity or repricing dates in accordance with their contractual terms. As described above, certain shortcomings are inherent in the method of analysis presented in this table.

 

     Three
Months
or
Less
    Over Three
Through

Twelve
Months
    Over One
Year
Through
Five Years
    Over
Five
Years
    Non-
Interest-
Bearing
    Total
     (Dollars in thousands)
Assets             

Interest-bearing deposits in other financial institutions

   $ 7,099      $ 9,701      $ —        $ —        $ —        $ 16,800

Investment in unconsolidated trust subsidiaries

     —          —          —          682        —          682

Securities available for sale

     63,080        22,570        17,072        13,761        —          116,483

Federal Reserve Bank and Federal Home Loan Bank stock

     13,603        —          —          —          —          13,603

Interest bearing deposits with financial institutions

     79,995        —          —          —          —          79,995

Loans held for sale, at

Fair value

     10,598        —          —          —          —          10,598

Loans, gross

     369,054        72,610        323,393        69,825        —          834,882

Non-interest earning assets, net

     —          —          —          —          37,490        37,490
                                              

Total assets

   $ 543,429      $ 104,881      $ 340,465      $ 84,268      $ 37,490      $ 1,110,533
                                              
Liabilities and Shareholders Equity             

Noninterest-bearing deposits

   $ —        $ —        $ —        $ —        $ 179,270      $ 179,270

Interest-bearing deposits(1) (2)

     295,474        313,127        69,667        —          —          678,268

Borrowings

     31,000        114,000        7,000        —          —          152,000

Junior subordinated debentures

     17,527        —          —          —          —          17,527

Other liabilities

     —          —          —          —          7,090        7,090

Shareholders’ equity

     —          —          —          —          76,378        76,378
                                              

Total liabilities and shareholders equity

   $ 344,001      $ 427,127      $ 76,667      $ —        $ 262,738      $ 1,110,533
                                              

Interest rate sensitivity gap

   $ 199,428      $ (322,246   $ 263,798      $ 84,268      $ (225,248   $ —  
                                              

Cumulative interest rate sensitivity gap

   $ 199,428      $ (122,818   $ 140,980      $ 225,248      $ —        $ —  
                                              

Cumulative % of rate sensitive assets in maturity period

     49     58     89     97     100  
                                          

Rate sensitive assets to rate sensitive liabilities and shareholders’ equity

     158     25     444     N/A        14  
                                          

Cumulative ratio

     158     84     117     127     100  
                                          

 

(1) Excludes savings accounts we maintain at the Bank totaling $3.9 million and maturing within three months of September 30, 2009.
(2) Excludes a $250,000 certificate of deposit issued to us by the Bank, which matures within 12 months of September 30, 2009.

 

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At September 30, 2009, our rate sensitive balance sheet was shown to be in a negative twelve-month gap position. This would imply that our net interest margin would decrease in the short–term if interest rates were to rise and would increase in the short-term if interest rates were to fall. However, as noted above, the extent to which our net interest margin will be impacted by changes in prevailing interests rates will depend on a number of factors, including how quickly rate sensitive assets and liabilities react to interest rate changes, the mix of our interest earning assets (loans versus other lower yielding interest earning assets, such as securities or federal funds sold) and the mix of our interest bearing deposits (between, for example, lower interest core deposits and higher cost time certificates of deposit) and our other interest-bearing liabilities.

Financial Condition

Assets

Our total consolidated assets decreased by $53 million to $1.111 billion at September 30, 2009 from $1.164 billion at December 31, 2008, as we recognized gains by selling our securities available for sale during the nine months ended September 30, 2009.

The following table sets forth the composition of our interest-earning assets (in thousands of dollars) at:

 

     September 30,
2009
   December 31,
2008

Interest-bearing deposits with financial institutions(1)

   $ 79,995    $ 90,707

Interest-bearing time deposits with financial institutions

     16,800      198

Federal Reserve Bank and Federal Home Loan Bank Stock, at cost

     13,603      13,420

Securities available for sale, at fair value

     116,483      160,945

Loans held for sale, at lower of cost or market

     10,598      —  

Loans (net of allowances of $17,180 and $15,453, respectively)

     817,652      828,041

 

(1) Includes interest-earning balances maintained at the Federal Reserve Bank of San Francisco.

Loans Held for Sale

We commenced a new mortgage banking business during the second quarter of 2009 to originate residential real estate mortgage loans that qualify for resale into the secondary mortgage markets. Through September 30, 2009, we had originated approximately $40.7 million of conventional and FHA/VA single-family mortgages and had sold approximately $28.9 million of those loans in the secondary mortgage market. The loans classified as loans held for sale are carried at the lower of cost or market. The remainder of the loans held for sale at September 30, 2009 totaled $10.6 million. Pursuant to ASC 815-10, in the three month period ended September 30, 2009 we recorded a positive mark-to-market valuation of $166,000 to noninterest income for the loans held for sale. During that period we did not establish any fair value hedges for these loans.

Loans

The following table sets forth, in thousands of dollars, the composition, by loan category, of our loan portfolio at September 30, 2009 and December 31, 2008, respectively:

 

     September 30, 2009     December 31, 2008  
     Amount     Percent     Amount     Percent  

Commercial loans

   $ 292,757      35.1   $ 300,945      35.7

Commercial real estate loans - owner occupied

     181,135      21.7     174,169      20.6

Commercial real estate loans - all other

     131,351      15.7     127,528      15.1

Residential mortgage loans - multi- family

     103,690      12.4     100,971      12.0

Residential mortgage loans - single-family

     63,616      7.6     65,127      7.7

Construction loans

     22,880      2.7     32,528      3.9

Land development loans

     31,607      3.8     33,283      3.9

Consumer loans

     8,164      1.0     9,173      1.1
                            

Gross loans(1)

     835,200      100.0     843,724      100.0
                

Deferred fee (income) costs, net

     (368       (230  

Allowance for loan losses

     (17,180       (15,453  
                    

Loans, net

   $ 817,652        $ 828,041     
                    

 

(1) Although, as indicated by this table, the volume of loans outstanding at September 30, 2009 was lower than at December 31, 2008, the average volume of loans outstanding during the nine months ended September 30, 2009 totaled $848 million, as compared to (i) $796 million for the same nine months of 2008 and $745 million for the year ended December 31, 2008.

 

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Commercial loans are loans to businesses to finance capital purchases or improvements, or to provide cash flow for operations. Commercial real estate and residential mortgage loans are loans secured by trust deeds on real property, including commercial property and single family and multi-family residences. Construction and land development loans are interim loans to finance specific construction projects. Consumer loans consist primarily of installment loans to consumers.

The following table sets forth, in thousands of dollars, the maturity distribution of our loan portfolio (excluding consumer and residential mortgage loans) at September 30, 2009:

 

     September 30, 2009
     One Year
or Less
   Over One
Year
through
Five Years
   Over Five
Years
   Total

Real estate and construction loans(1)

           

Floating rate

   $ 50,822    $ 120,296    $ 9,625    $ 180,743

Fixed rate

     58,884      88,725      38,621      186,230

Commercial loans

           

Floating rate

     57,526      2,457      —        59,983

Fixed rate

     147,057      59,128      26,589      232,774
                           

Total

   $ 314,289    $ 270,606    $ 74,835    $ 659,730
                           

 

(1) Does not include mortgage loans on single and multi-family residences and consumer loans, which totaled $167.3 million and $8.2 million, respectively, at September 30, 2009.

Allowance for Loan Losses and Nonperforming Loans

Allowance for Loan Losses. The allowance for loan losses (the “Allowance”) at September 30, 2009 was $17.2 million, which represented approximately 2.06% of the loans outstanding at September 30, 2009, as compared to $15.5 million, or 1.83%, of the loans outstanding at December 31, 2008.

We carefully monitor changing economic conditions, the loan portfolio by category, the financial condition of borrowers, the historical performance of the loan portfolio, and we follow bank regulatory guidelines in assessing the adequacy of the Allowance. We believe that the Allowance at September 30, 2009 was adequate to provide for losses inherent in the loan portfolio. However, as the volume of loans increases, additional provisions for loan losses may be required to maintain the Allowance at adequate levels. Additionally, the Allowance was established on the basis of assumptions and judgments regarding such matters as economic conditions and trends, the condition of borrowers, historical industry loan loss data and regulatory guidelines. If there are changes in those conditions or trends, as occurred during the nine months ended September 30, 2009, actual loan losses could vary from the losses that were predicted on the basis of those earlier assumptions, judgments and guidelines. For example, if current economic conditions were to deteriorate further or if the hoped-for economic recovery is slow to develop, or interest rates were to increase significantly, each of which would have the effect of increasing the risk that borrowers would encounter difficulties meeting their loan payment obligations, we could incur additional loan losses and, as a result, it could become necessary to increase the Allowance by means of additional provisions for loan losses. See “—Results of Operations—Provision for Loan Losses” above.

Set forth below is a summary, in thousands of dollars, of the transactions in the allowance for loan losses for the three and nine months ended September 30, 2009 and the year ended December 31, 2008:

 

     Three Months Ended
September 30, 2009
    Nine Months Ended
September 30, 2009
    Year Ended
December 31, 2008
 

Balance, beginning of period

   $ 20,442      $ 15,453      $ 6,126   

Provision for loan losses

     470        10,513        21,685   

Recoveries on loans previously charged off

     21        116        80   

Amounts charged off

     (3,753     (8,902     (12,438
                        

Balance, end of period

   $ 17,180      $ 17,180      $ 15,453   
                        

 

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Non-Performing Loans. We also measure and establish reserves for loan impairments on a loan-by-loan basis using either the present value of expected future cash flows discounted at a loan’s effective interest rate, or the fair value of the collateral if the loan is collateral-dependent. We exclude smaller, homogeneous loans, such as consumer installment loans and lines of credit, from our impairment calculations. Also, loans that experience insignificant payment delays or shortfalls are generally not considered impaired. We generally cease accruing interest and, therefore, classify as nonaccrual, any loan as to which principal or interest has been in default for a period of 90 days or more, or as to which repayment in full of interest or principal is not expected.

The following table sets forth information regarding nonaccrual loans and other real estate owned which, together, comprise our nonperforming assets, and restructured loans, at September 30, 2009 and December 31, 2008:

 

     At September 30, 2009    At December 31, 2008

Nonaccrual loans:

     

Commercial loans

   $ 23,280    $ 5,865

Commercial real estate

     20,689      —  

Residential real estate

     599      2,478

Construction and land development

     15,008      7,555

Consumer loans

     —        27
             

Total nonaccrual loans

   $ 59,576    $ 15,925
             

Other real estate owned (OREO):

     

Construction and land development

     4,465      5,430

Residential-multi family

     —        976

Residential-single family

     5,297      2,408

Commercial real estate

     4,230      5,194
             

Total other real estate owned

     13,992      14,008
             

Total nonperforming assets

   $ 73,568    $ 29,933
             

Restructured loans:

     

Accruing loans

     2,422      2,606

Nonaccruing loans (included in nonaccrual loans above)

     19,831      4,913
             

Total Restructured Loans

   $ 22,253    $ 7,519
             

Although nonaccrual loans increased by approximately $43.7 million to $59.6 million at September 30, 2009 from $15.9 million at December 31, 2008, approximately $41.5 million, or 70%, of nonaccrual loans outstanding at September 30, 2009, are secured either directly or indirectly by real estate collateral which is expected to mitigate any losses we might incur on those loans. We also have either charged off or set aside reserves specifically for these loans, based on recent appraisals of those properties. Based primarily on the current values of the real estate collateral securing most of these loans, those specifically allocated reserves total less than $500,000. In addition, the remaining $18.1 million in nonaccrual loans are secured by other non-real estate collateral. There can be no assurance, however, that we will not incur losses in a greater amount on these loans, particularly if real property values continue to decline or the credit crisis makes it difficult to find buyers for these properties.

Loans that have been restructured and referred to as Troubled Debt Restructures (“TDR”) remain in a nonaccrual status until there has been six months of satisfactory performance by the borrowers in accordance with the restructured terms of those loans, at which time the loans would be returned to accrual status. We have entered into troubled debt restructuring agreements on $19.8 million of loans carried on a nonaccrual basis and we expect that some portion of those loans will perform as structured for that six month period, in which event they will return to accrual status during the first quarter of 2010.

On October 15, 2009, we completed the sale of an OREO property with a carrying value of $1.5 million and we have entered into an agreement to sell another OREO property with a carrying value of $4.2 million that is scheduled to close on or before November 30, 2009. No material additional losses were recognized on the property sold in October 2009 and, if we succeed in closing the sale of the property that is scheduled to close by the end of November 2009, we do not expect to incur any material additional loss on that property. On the other hand, as of September 30, 2009, we were in the process of foreclosing two other properties collateralizing non-performing loans with an estimated current market value totaling approximately $2.1 million. As a result, we may incur losses on those properties before we can complete their sale.

At September 30, 2009, there were $62.0 million of loans deemed impaired as compared to $15.9 million at September 30, 2008. We had an average investment in impaired loans for the nine months ended September 30, 2009 of $49.8 million as compared to $17.8 million for the year ended December 31, 2008. The interest that would have been earned during the nine month period ended September 30, 2009 had the impaired loans remained current in accordance with their original terms was $1.7 million.

The table below indicates the trend in loan delinquencies, by quarter, from September 30, 2008 to September 30, 2009.

 

     2009    2008
     At September 30    At June 30    At March 31    At December 31    At September 30
     (In thousands)

Loans Delinquent:

              

90 days or more:

              

Commercial loans

   $ 15,220    $ 8,880    $ 762    $ 1,653    $ 3,920

Commercial real estate

     10,049      11,724      3,133           6,785

Residential mortgages

     269      346      1,166      1,353      399

Construction and land development loans

     6,030      6,463      2,504      3,779      4,665

Consumer loans

     —        17      27      27      78
                                  
     31,568      27,430      7,592      6,812      15,847
                                  

30-89 days:

              

Commercial loans

     3,652      12,623      2,986      11,209      380

Commercial real estate

     364      2,242      —        3,133      —  

Residential mortgages

     1,152      270      346      —        348

Construction and land development loans

     2,215      —        6,409      10,725      7,975

Consumer loans

     248      —        —        44      —  
                                  
     7,631      15,135      9,741      25,111      8,703
                                  

Total Past Due(1):

   $ 39,199    $ 42,565    $ 17,333    $ 31,923    $ 24,550
                                  

 

 

(1) Past due balances include nonaccrual loans.

Total loan past due totaled $39.2 million at September 30, 2009, a decrease of $3.4 million, or 8%, as compared to $42.3 million at June 30, 2009. Loan delinquencies of 90 days or more totaled $31.6 million at September 30, 2009, an increase of $4.2 million, or 15%, as compared to $27.4 million at June 30, 2009, while loans 30 to 89 days delinquent declined to $7.6 million, at September 30, 2009, a decrease of $7.5 million, or 50%, as compared to $15.1 million at June 30, 2009.

Deposits

Average Balances of and Average Interest Rates Paid on Deposits.

Set forth below are the average amounts (in thousands of dollars) of, and the average rates paid on, deposits in the nine months ended September 30, 2009:

 

     Nine Months Ended
September 30, 2009
 
     Average
Balance
   Average
Rate
 

Noninterest-bearing demand deposits

   $ 165,709    —     

Interest-bearing checking accounts

     26,036    0.61

Money market and savings deposits

     105,473    1.18

Time deposits

     604,152    3.68
         

Average total deposits

   $ 901,370    2.63
         

 

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Deposit Totals. Deposits totaled $858 million at September 30, 2009 as compared to $822 million at December 31, 2008. At September 30, 2009, noninterest-bearing deposits totaled $179 million and represented 21% of total deposits, as compared to $152 million and 19% of total deposits at December 31, 2008. At September 30, 2009, certificates of deposit in denominations of $100,000 or more totaled $384 million and represented 45% of total deposits, as compared to $326 million and 40% of total deposits at December 31, 2008. Due to the deterioration of the economy and continuing uncertainties as to the ultimate severity and duration of the economic recession and credit crisis, we decided to increase the Bank’s liquidity by increasing the volume of the time certificates of deposits in the first half of 2009, the proceeds of which were used primarily to reduce long term borrowings and to fund increases in loans and short-term interest-earning assets. During the third quarter of 2009, we were able to decrease the volume of our time deposits by $81 million to $549 million from $630 million at June 30, 2009, by replacing the cash provided by those deposits with cash from the sale of securities available for sale.

Set forth below, in thousands of dollars, is a maturity schedule of domestic time certificates of deposit outstanding at September 30, 2009:

 

     At September 30, 2009
     Certificates
of Deposit
Under
$100,000
   Certificates
of Deposit
of $100,000
or More

Maturities

     

Three months or less

   $ 60,893    $ 189,793

Over three and through twelve months

     76,820      143,110

Over twelve months

     27,569      50,600
             

Total certificates of deposit

   $ 165,282    $ 383,503
             

Liquidity

We actively manage our liquidity needs to ensure that sufficient funds are available to meet our needs for cash, including to fund new loans to and deposit withdrawals by our customers. We project the future sources and uses of funds and maintain liquid funds for unanticipated events. Our primary sources of cash include cash we have on deposit at other financial institutions, payments on loans, proceeds from the sale or maturity of securities, and from sales of residential mortgage loans, increases in deposits and increases in borrowings principally from the Federal Home Loan Bank. The primary uses of cash include funding new loans and making advances on existing lines of credit, purchasing investments, including securities available for sale, funding new residential mortgage loans, funding deposit withdrawals and paying operating expenses. We maintain funds in overnight federal funds and other short-term investments to provide for short-term liquidity needs. We also have obtained credit lines from the Federal Home Loan Bank and other financial institutions to meet any additional liquidity requirements.

Our liquid assets, which included cash and due from banks, federal funds sold, interest earning deposits with financial institutions and unpledged securities available for sale (excluding Federal Reserve Bank and Federal Home Loan Bank stock) totaled $127 million, which represented 11.5% of total assets, at September 30, 2009.

Cash Flow Used in Operating Activities. We used net cash flow of $16.7 million from operating activities primarily to fund the net loss of $8.6 million in the nine months ended September 30, 2009, and to fund the origination of $39.1 million of mortgage loans, partially offset by $28.9 million in proceeds on sales of mortgage loans.

Cash Flow Provided by Investing Activities. In the nine months ended September 30, 2009, investing activities provided net cash of $46.5 million, comprised of cash from sales of securities available for sale totaling $187.7 million, $12 million received from maturities and interest on securities available for sale, substantially offset by purchases of a total of $136.6 million of securities available for sale and purchases by us of $16.6 million in time deposits at other financial institutions.

Cash Flow Used by Financing Activities. We used net cash flow of $45.9 million in financing activities during the nine months ended September 30, 2009, to fund a net decrease of $81.8 million in borrowings, partially offset by a net increase of $35.9 million in deposits.

Ratio of Loans to Deposits. The relationship between gross loans and total deposits can provide a useful measure of a bank’s liquidity. Since repayment of loans tends to be less predictable than the maturity of investments and other liquid resources, the higher the loan-to-deposit ratio the less liquid are our assets. On the other hand, since we realize greater yields on loans than we do on investments, a lower loan-to-deposit ratio can adversely affect interest income and earnings. As a result, our goal is to achieve a loan-to-deposit ratio that appropriately balances the requirements of liquidity and the need to generate a fair return on assets. At September 30, 2009 and December 31, 2008, the ratios of loans-to-deposits were 95% and 101%, respectively. The reduction in that ratio at September 30, 2009, as compared to December 31, 2008, was primarily attributable to our decision to increase our liquidity, which we believe was prudent due to the continuing economic recession and credit crisis and uncertainties as to their ultimate duration.

 

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Off Balance Sheet Arrangements

Loan Commitments and Standby Letters of Credit. In order to meet the financing needs of our customers, in the normal course of business we make commitments to extend credit and issue standby commercial letters of credit to or for our customers. At September 30, 2009 and December 31, 2008, we were committed to fund certain loans, including letters of credit, amounting to approximately $216 million and $218 million, respectively.

Commitments to extend credit and standby letters of credit generally have fixed expiration dates or other termination clauses and the customer may be required to pay a fee and meet other conditions in order to draw on those commitments or standby letters of credit. We expect, based on historical experience, that many of the commitments will expire without being drawn upon and, therefore, the total commitment amounts do not necessarily represent future cash requirements.

To varying degrees, commitments to extend credit involve elements of credit and interest rate risk for us that are in excess of the amounts recognized in our balance sheets. Our maximum exposure to credit loss in the event of nonperformance by the customers to whom such commitments are made could potentially be equal to the amount of those commitments. As a result, before making such a commitment to a customer, we evaluate the customer’s creditworthiness using the same underwriting standards that we would apply if we were approving loans to the customer. In addition, we often require the customer to secure its payment obligations for amounts drawn on such commitments with collateral such as accounts receivable, inventory, property, plant and equipment, income-producing commercial properties, residential properties and properties under construction. As a consequence, our exposure to credit and interest rate risk on such commitments is not different in character or amount than risks inherent in the outstanding loans in our loan portfolio.

Standby letters of credit are conditional commitments issued by the Bank to guarantee a payment obligation of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan commitments to customers.

We believe that our cash and cash equivalent resources, together with available borrowings under our credit facilities, will be sufficient to enable us to meet any increases in demand for loans or in the utilization of outstanding loan commitments or standby letters of credit and any increase in deposit withdrawals that might occur in the foreseeable future.

Contractual Obligations

Borrowings. As a source of additional funds that we have used primarily to fund loans and to purchase other interest earning assets, and to provide us with a supplemental source of liquidity, we have obtained long and short term borrowings from the Federal Home Loan Bank (the “FHLB”). As of September 30, 2009, we had $17 million of outstanding long-term borrowings, with maturities in December 2010, and $135 million of outstanding short-term borrowings, with maturities ranging from November 2009 to June 2010 that we had obtained from the Federal Home Loan Bank. These borrowings have a weighted-average annualized interest rate of 4.11%. By comparison, as of December 31, 2008, we had $121 million of outstanding long-term borrowings and $104 million of outstanding short-term borrowings that we had obtained from the Federal Home Loan Bank, which, together with the securities sold under agreements to repurchase, had a weighted-average annualized interest rate of 3.78%.

At September 30, 2009, U.S. agency and mortgage backed securities, U.S. Government agency securities, collateralized mortgage obligations and time deposits with an aggregate fair market value of $98 million and $188 million of residential mortgage and other real estate secured loans were pledged to secure these Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits, and treasury, tax and loan accounts.

The highest amount of borrowings that were outstanding at any month-end during the nine months ended September 30, 2009 consisted of $208 million of borrowings from the Federal Home Loan Bank and $13 million of overnight borrowings in the form of securities sold under repurchase agreements. During 2008, the highest amount of borrowings outstanding at any month-end consisted of $236 million of advances from the Federal Home Loan Bank and $13 million of overnight borrowings in the form of securities sold under repurchase agreements.

 

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Junior Subordinated Debentures. Pursuant to rulings of the Federal Reserve Board, bank holding companies are permitted to issue long term subordinated debt instruments that will, subject to certain conditions, qualify as and, therefore, augment capital for regulatory purposes. At September 30, 2009, we had outstanding approximately $17.5 million principal amount of 30-year junior subordinated floating rate debentures (the “Debentures”). The Debentures are redeemable at our option, without premium or penalty, beginning five years after their respective original issue dates, and require quarterly interest payments. Subject to certain conditions, we have the right, at our discretion, to defer those interest payments for up to five years. However, we do not have any present plans to exercise this deferral right.

Set forth below is certain information regarding the terms of the Debentures that remained outstanding as of September 30, 2009:

 

Original Issue Dates

   Principal Amount    Interest Rates     Maturity Dates
     (In thousands)           

September 2002

   $ 7,217    LIBOR plus 3.40   September 2032

October 2004

     10,310    LIBOR plus 2.00   October 2034
           

Total

   $ 17,527     
           

Under the Federal Reserve Board rulings, the borrowings evidenced by the Debentures, which are subordinated to all of our other borrowings that are outstanding or which we may obtain in the future, are eligible (subject to certain dollar limitations) to qualify, and at September 30, 2009, all $17.5 million principal amount of those Debentures qualified, as Tier I capital for regulatory purposes. See discussion below under the subcaption “—Capital Resources-Regulatory Capital Requirements.”

Investment Policy and Securities Available for Sale

Our investment policy is designed to provide for our liquidity needs and to generate a favorable return on investments without undue interest rate risk, credit risk or asset concentrations.

Our investment policy:

 

   

authorizes us to invest in obligations issued or fully guaranteed by the United States Government, certain federal agency obligations, time deposits issued by federally insured depository institutions, municipal securities and in federal funds sold;

 

   

provides that the weighted average maturities of U.S. Government obligations and federal agency securities cannot exceed 10 years and municipal obligations cannot exceed 25 years;

 

   

provides that time deposits must be placed with federally insured financial institutions, cannot exceed the current federally insured amount in any one institution and may not have a maturity exceeding 60 months, unless that time deposit is matched to a liability instrument issued by the Bank; and

 

   

prohibits engaging in securities trading activities.

 

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Securities available for sale are those that we intend to hold for an indefinite period of time, but which may be sold in response to changes in liquidity needs, changes in interest rates, changes in prepayment risks or other similar factors. Such securities are recorded at fair value. Any unrealized gains and losses are reported as “Other Comprehensive Income (Loss)” rather than included in or deducted from earnings.

The following is a summary of the major components of securities available for sale and a comparison of the amortized cost, estimated fair values and gross unrealized gains and losses, in thousands of dollars, as of September 30, 2009 and December 31, 2008:

 

     Amortized
Cost
   Gross
Unrealized
Gain
   Gross
Unrealized
Loss
    Estimated
Fair Value

September 30, 2009

          

Securities Available For Sale:

          

US Treasury securities

   $ 72,843    $ 133    $ —        $ 72,976

Mortgage-backed securities issued by US agencies

     12,457      65      (67     12,455

Collateralized mortgage obligations issued by US agencies

     6,829      —        (43     6,786
                            

Total securities issued or guaranteed by US government or US agencies

     92,129      198      (110     92,217

Municipal securities

     14,180      149      (182     14,147

Non-agency collateralized mortgage obligations

     7,704      —        (1,337     6,367

Asset-backed securities

     2,737      —        (1,277     1,460

Mutual fund

     2,292      —        —          2,292
                            

Total Securities Available For Sale

   $ 119,042    $ 347    $ (2,906   $ 116,483
                            

December 31, 2008

          

Securities Available For Sale:

          

US agencies and mortgage-backed securities

   $ 126,065    $ 1,538    $ (471   $ 127,132

Collateralized mortgage obligations

     425      4      —          429
                            

Total government and agencies securities

     126,490      1,542      (471     127,561

Municipal securities

     22,895      90      (1,523     21,462

Non-agency collateralized mortgage obligations

     10,278      —        (1,340     8,938

Asset backed securities

     1,237      —        —          1,237

Mutual fund

     1,747      —        —          1,747
                            

Total Securities Available For Sale

   $ 162,647    $ 1,632    $ (3,334   $ 160,945
                            

At September 30, 2009, U.S. agencies and mortgage backed securities, U.S. Government agency securities, collateralized mortgage obligations and time deposits with an aggregate fair market value of $108 million were pledged to secure Federal Home Loan Bank borrowings, repurchase agreements, local agency deposits, to secure lines of credit at our correspondent banks and treasury, tax and loan accounts.

 

36


Table of Contents

The amortized cost, at September 30, 2009, of securities available for sale are shown, in thousands of dollars, in the following table, by contractual maturities and historical prepayments based on the prior three months of principal payments. Expected maturities will differ from contractual maturities and historical prepayments, particularly with respect to collateralized mortgage obligations, because borrowers may react to interest rate market conditions differently than the historical prepayment rates.

 

     September 30, 2009
Maturing in
 
     One year
or less
    Over one
year through
five years
    Over five
years through
ten years
    Over ten
years
    Total  
     Book
Value
   Weighted
Average
Yield
    Book
Value
   Weighted
Average
Yield
    Book
Value
   Weighted
Average
Yield
    Book
Value
   Weighted
Average
Yield
    Book
Value
   Weighted
Average
Yield
 
     (Dollars in thousands)  

Securities available for sale:

                &n