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EX-32 - EXHIBIT 32 - SIERRA BANCORPv221013_ex32.htm
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EX-31.1 - EXHIBIT 31.1 - SIERRA BANCORPv221013_ex31-1.htm

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2011

Commission file number:  000-33063

SIERRA BANCORP
(Exact name of Registrant as specified in its charter)

California
33-0937517
(State of Incorporation)
(IRS Employer Identification No)

86 North Main Street, Porterville, California  93257
(Address of principal executive offices)                  (Zip Code)

(559) 782-4900
(Registrant’s telephone number, including area code)

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

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

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T 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.
Large accelerated filer £
Accelerated filer R
 
Non-accelerated filer £ (Do not check if a smaller reporting company)
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  R

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

Common stock, no par value, 14,003,761 shares outstanding as of May 2, 2011

 
 

 

FORM 10-Q

Table of Contents
 
Page
Part I - Financial Information
1
Item 1. Financial Statements (Unaudited)
1
Consolidated Balance Sheets
1
Consolidated Statements of Income
2
Consolidated Statements of Cash Flows
3
Notes to Unaudited Consolidated Financial Statements
4
   
Item 2. Management’s Discussion & Analysis of Financial Condition & Results of Operations
12
Forward-Looking Statements
12
Critical Accounting Policies
12
Overview of the Results of Operations and Financial Condition
13
Earnings Performance
14
Net Interest Income and Net Interest Margin
14
Provision for Loan and Lease Losses
17
Non-interest Revenue and Operating Expense
17
Provision for Income Taxes
20
Balance Sheet Analysis
20
Earning Assets
20
Investments
20
Loan Portfolio
22
Credit Quality and Nonperforming Assets
23
Allowance for Loan and Lease Losses
27
Off-Balance Sheet Arrangements
32
Other Assets
32
Deposits and Interest-Bearing Liabilities
33
Deposits
33
Other Interest-Bearing Liabilities
34
Non-Interest Bearing Liabilities
34
Liquidity and Market Risk Management
34
Capital Resources
37
   
Item 3. Qualitative & Quantitative Disclosures about Market Risk
38
   
Item 4. Controls and Procedures
38
   
Part II - Other Information
39
Item 1. - Legal Proceedings
39
Item 1A. - Risk Factors
39
Item 2. - Unregistered Sales of Equity Securities and Use of Proceeds
39
Item 3. - Defaults upon Senior Securities
39
Item 4. - (Removed and Reserved)
39
Item 5. - Other Information
39
Item 6. - Exhibits
40
   
Signatures
41

 
 

 

PART I - FINANCIAL INFORMATION
Item 1
 
SIERRA BANCORP
CONSOLIDATED BALANCE SHEETS
(dollars in thousands)

   
March 31, 2011
   
December 31, 2010
 
 
 
(unaudited)
   
(audited)
 
ASSETS                
Cash and due from banks
  $ 46,149     $ 42,110  
Interest-bearing deposits in other banks
    11,373       325  
Federal funds sold
    -       210  
Total Cash & Cash Equivalents
    57,522       42,645  
Investment securities available for sale
    375,027       331,730  
Loans and leases:
               
Gross loans and leases
    776,392       805,540  
Allowance for loan and lease losses
    (21,464 )     (21,138 )
Deferred loan and lease fees, net
    188       113  
Net Loans and Leases
    755,116       784,515  
Premises and equipment, net
    20,608       20,190  
Other assets
    104,676       107,491  
TOTAL ASSETS
  $ 1,312,949     $ 1,286,571  
                 
LIABILITIES AND SHAREHOLDERS' EQUITY
               
LIABILITIES
               
Deposits:
               
Non-interest bearing
  $ 266,209     $ 251,908  
Interest bearing
    825,496       800,366  
Total Deposits
    1,091,705       1,052,274  
Federal funds purchased and repurchase agreements
    35       -  
Short-term borrowings
    -       14,650  
Long-term borrowings
    15,000       15,000  
Other liabilities
    13,758       14,122  
Junior subordinated debentures
    30,928       30,928  
TOTAL LIABILITIES
    1,151,426       1,126,974  
SHAREHOLDERS' EQUITY
               
Serial Preferred stock, no par value; 10,000,000 shares authorized; none issued
    -       -  
Common stock, no par value; 24,000,000 shares authorized; 13,985,761 and 13,976,741 shares issued and outstanding at March 31, 2011 and December 31, 2010, respectively
    63,550       63,477  
Additional paid in capital
    1,718       1,652  
Retained earnings
    94,261       93,570  
Accumulated other comprehensive income
    1,994       898  
TOTAL SHAREHOLDERS' EQUITY
    161,523       159,597  
                 
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY
  $ 1,312,949     $ 1,286,571  

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

 
1

 

SIERRA BANCORP
CONSOLIDATED  STATEMENTS OF INCOME
(dollars in thousands, except per share data, unaudited)

   
For the Quarter
 
   
Ended March 31,
 
 
 
2011
   
2010
 
Interest income:                 
Interest and fees on loans
  $ 11,782     $ 13,578  
Interest on investment securities:
               
Taxable
    1,916       2,108  
Tax-exempt
    716       644  
Interest on federal funds sold and interest-bearing Deposits
    8       17  
Total interest income
    14,422       16,347  
                 
Interest expense:
               
Interest on deposits
    1,091       1,658  
Interest on short-term borrowings
    34       38  
Interest on long-term borrowings
    140       176  
Interest on manditorily redeemable trust preferred securities
    181       175  
Total interest expense
    1,446       2,047  
                 
Net Interest Income
    12,976       14,300  
                 
Provision for loan losses
    3,600       3,400  
                 
Net Interest Income after Provision for Loan Losses
    9,376       10,900  
                 
Non-interest revenue:
               
Service charges on deposit accounts
    2,255       2,703  
Other
    1,321       1,158  
Total other operating income
    3,576       3,861  
                 
Other operating expense:
               
Salaries and employee benefits
    5,710       5,779  
Occupancy expense
    1,575       1,740  
Other
    4,417       4,654  
Total other operating expenses
    11,702       12,173  
                 
Income before income taxes
    1,250       2,588  
                 
Provision for income taxes
    (279 )     249  
                 
Net Income
  $ 1,529     $ 2,339  
                 
PER SHARE DATA
               
Book value
  $ 11.55     $ 11.77  
Cash dividends
  $ 0.06     $ 0.06  
Earnings per share basic
  $ 0.11     $ 0.20  
Earnings per share diluted
  $ 0.11     $ 0.20  
Average shares outstanding, basic
    13,981,780       11,630,773  
Average shares outstanding, diluted
    14,060,661       11,693,589  

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

 
2

 

SIERRA BANCORP
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands, unaudited)

   
Three Months Ended March 31,
 
   
2011
   
2010
 
Cash Flows from Operating Activities   
           
Net income
  $ 1,529     $ 2,339  
Adjustments to reconcile net income to net cash provided by operating activities:
               
Gain on investment of securities
  $ -     $ -  
Gain on sales of loans
    (43 )     (24 )
Loss on disposal of fixed assets
    53       108  
(Gain) Loss on sale on foreclosed assets
    (18 )     10  
Writedown on foreclosed assets
    458       267  
Share-based compensation expense
    64       38  
Provision for loan losses
    3,600       3,400  
Depreciation and amortization
    644       743  
Net amortization on securities premiums and discounts
    1,259       581  
Increase in unearned net loan fees
    (76 )     (68 )
Increase in cash surrender value of life insurance policies
    (419 )     (420 )
Proceeds from sales of loans portfolio
    1,154       1,968  
Net decrease (increase) in loans held-for-sale
    870       (140 )
Decrease in interest receivable and other assets
    716       644  
Decrease in other liabilities
    (363 )     (1,460 )
Net decrease in FHLB Stock
    316       -  
Deferred Income Tax (Benefit) Provision
    (3 )     7  
Excess tax benefit from equity based compensation
    (1 )     -  
Net cash provided by operating activities
    9,740       7,993  
                 
Cash flows from investing activities:
               
Maturities of securities available for sale
    -       2,147  
Proceeds from sales/calls of securities available for sale
    1,275       1,375  
Purchases of securities available for sale
    (62,148 )     (36,386 )
Principal paydowns on securities available for sale
    18,156       16,442  
Decrease in loans receivable, net
    22,327       5,836  
Purchases of premises and equipment, net
    (988 )     (538 )
Proceeds from sales of foreclosed assets
    2,463       808  
Net cash used in investing activities
    (18,915 )     (10,316 )
                 
Cash flows from financing activities:
               
Increase (decrease) in deposits
    39,431       (17,432 )
Decrease in borrowed funds
    (14,650 )     (3,850 )
Increase in Fed funds purchased
    35       -  
Cash dividends paid
    (839 )     (698 )
Stock options exercised
    74       81  
Excess tax benefit from equity based compensation
    1       -  
Net cash provided by (used in) financing activities
    24,052       (21,899 )
                 
Increase (Decrease) in cash and due from banks
    14,877       (24,222 )
                 
Cash and Cash Equivalents
               
Beginning of period
    42,645       66,235  
End of period
  $ 57,522     $ 42,013  

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

 
3

 

SIERRA BANCORP
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011

Note 1 – The Business of Sierra Bancorp

Sierra Bancorp (the “Company”), headquartered in Porterville, California, is a California corporation registered as a bank holding company under the Bank Holding Company Act of 1956, as amended.  The Company was incorporated in November 2000 and acquired all of the outstanding shares of Bank of the Sierra (the “Bank”) in August 2001.  The Company’s principal subsidiary is the Bank, and the Company exists primarily for the purpose of holding the stock of the Bank and of such other subsidiaries it may acquire or establish.  At the present time, the Company’s only other direct subsidiaries are Sierra Statutory Trust II and Sierra Capital Trust III, which were formed in March 2004 and June 2006, respectively, solely to facilitate the issuance of capital trust pass-through securities.  Pursuant to the Financial Accounting Standards Board’s (FASB’s) standard on the consolidation of variable interest entities, these trusts are not reflected on a consolidated basis in the financial statements of the Company.  References herein to the “Company” include Sierra Bancorp and its consolidated subsidiary, the Bank, unless the context indicates otherwise.

The Bank is a California state-chartered bank headquartered in Porterville, California, that offers a full range of retail and commercial banking services to communities in the central and southern sections of the San Joaquin Valley.  Our branch footprint stretches from Fresno on the north to Bakersfield on the south, and on the southern end extends east through the Tehachapi plateau and into the northwestern tip of the Mojave Desert.  The Bank was incorporated in September 1977 and opened for business in January 1978, and in the ensuing years has grown to be the largest independent bank headquartered in the South San Joaquin Valley.  Our growth has primarily been organic, but includes the acquisition of Sierra National Bank in 2000.  We currently operate 25 full service branch offices throughout our geographic footprint, as well as an internet branch which provides the ability to open deposit accounts and submit certain loan applications online.  The Bank’s newest “brick and mortar” branches opened for business in Selma in February 2011 and Farmersville in March 2010.  In January 2011 we closed our first branch ever, in Bakersfield on California Avenue, due to lease issues.  In addition to our full-service branches, the Bank has an agricultural credit division and an SBA lending unit with staff located at our corporate headquarters, and offsite ATM’s at eight different non-branch locations.  The Bank’s deposit accounts are insured by the Federal Deposit Insurance Corporation (FDIC) up to maximum insurable amounts.

Note 2 – Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in a condensed format, and therefore do not include all of the information and footnotes required by U.S. generally accepted accounting principles (GAAP) for complete financial statements.  The information furnished in these interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for such period.  Such adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q.  In preparing the accompanying consolidated financial statements, management has taken subsequent events into consideration and recognized them where appropriate.  The results of operations in the interim statements are not necessarily indicative of the results that may be expected for any other quarter, or for the full year.  Certain amounts reported for 2010 have been reclassified to be consistent with the reporting for 2011.  The interim financial information should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, as filed with the Securities and Exchange Commission.

 
4

 

Note 3 – Current Accounting Developments

On April 5, 2011, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standards Update (“ASU”) No. 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring, in an effort to improve financial reporting by creating greater consistency in the way GAAP is applied for various types of debt restructurings.  ASU 2011-02 is intended to assist creditors in determining whether a modification of the terms of a loan meets the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for disclosure of troubled debt restructurings.  In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist:  1) the restructuring constitutes a concession; and 2) the debtor is experiencing financial difficulties.  The amendments to Topic 310 clarify the guidance on a creditor’s evaluation of whether it has granted a concession, and likewise clarify the guidance on a creditor’s evaluation of whether a debtor is experiencing financial difficulties.  In addition, the amendments to Topic 310 preclude creditors from using the effective interest rate test in the debtor’s guidance on restructuring of payables (paragraph 470-60-55-10) when evaluating whether a restructuring constitutes a troubled debt restructuring.  For public companies, such as Sierra Bancorp, the new guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the fiscal year of adoption.  We have a number of loans that are not currently classified as troubled-debt restructurings, where interest rates on the loans have been adjusted to current market levels.  While we have not yet examined all of those loans in detail to determine if this new guidance will result in reclassifications, the adoption of ASU 2011-02 for the third quarter of 2011 could result in a higher level of troubled debt restructurings than currently disclosed by the Company.

In July 2010, the FASB updated disclosure requirements with respect to the credit quality of financing receivables and the allowance for credit losses.  According to the guidance, there are two levels of detail at which credit information must be presented - the portfolio segment level and class level.  The portfolio segment level is defined as the level where financing receivables are aggregated in developing a company’s systematic method for calculating its allowance for credit losses.  The class level is the second level at which credit information will be presented, and represents the categorization of financing receivables at a slightly less aggregated level than the portfolio segment level.  Companies will now be required to provide the following disclosures as a result of this update:  A roll-forward of the allowance for credit losses at the portfolio segment level, with the ending balances further categorized according to impairment method along with the balance reported in the related financing receivables at period-end; additional disclosures of nonaccrual and impaired financing receivables by class as of period-end; credit quality and past due/aging information by class as of period-end; information surrounding the nature and extent of loan modifications and troubled-debt restructurings and their effect on the allowance for credit losses during the period; and details on any significant purchases or sales of financing receivables during the period.  The increased period-end disclosure requirements become effective for periods ending on or after December 15, 2010, with the exception of the additional disclosures surrounding troubled-debt restructurings which were deferred in December 2010 and are required for annual and interim reporting periods ending on or after June 15, 2011.  The increased disclosures for activity within a reporting period become effective for periods beginning on or after June 15, 2011, and should be applied retrospectively to January 1, 2011.  The provisions of this FASB update expanded the Company’s current disclosures with respect to our allowance for loan and lease losses and the credit quality of our financing receivables.

In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.  This update added disclosure requirements for significant transfers into and out of Levels 1 and 2, clarified existing fair value disclosure requirements about the appropriate level of disaggregation, and clarified that a description of the valuation techniques was required for recurring and nonrecurring Level 2 and 3 fair value measurements.  The Company adopted these provisions of the ASU in preparing the Consolidated Financial Statements for the period ended March 31, 2010.  The adoption of these provisions only affected the disclosure requirements for fair value measurements and as a result had no impact on the Company’s statements of income and condition.  An additional requirement of this ASU is that activity within Level 3, including purchases, sales, issuances, and settlements, be presented on a gross basis rather than as a net number as currently permitted.  This provision of the ASU is effective for the Company’s reporting period ending March 31, 2011, i.e. for this report on 10-Q.  As this provision only amends the disclosure requirements for fair value measurements, our adoption of it had no impact on the Company’s statements of income and condition.

Note 4 – Supplemental Disclosure of Cash Flow Information

During the three months ended March 31, 2011 and 2010, cash paid for interest due on interest-bearing liabilities was $1.3 million and $2.5 million, respectively.  There was no cash paid for income taxes during the three months ended March 31, 2011, and $2.3 million in cash paid for income taxes during the three months ended March 31, 2010.  Assets totaling $1.9 million and $2.9 million were acquired in the settlement of loans for the three months ended March 31, 2011 and March 31, 2010, respectively, while $2.4 million in foreclosed assets were sold during the first three months of 2011 relative to $690,000 sold during the first three months of 2010.  The Company extended $1.4 million in loans to finance the sale of other real estate during the three months ended March 31, 2011, but no such loans were made for the three months ended March 31, 2010.

 
5

 

Note 5 – Share Based Compensation

The 2007 Stock Incentive Plan (the “2007 Plan”) was adopted by the Company in 2007.  Our 1998 Stock Option Plan (the “1998 Plan”) was concurrently terminated, although options to purchase 350,358 shares that were granted prior to the termination of the 1998 Plan were still outstanding as of March 31, 2011 and remain unaffected by the termination.  The 2007 Plan provides for the issuance of both “incentive” and “nonqualified” stock options to officers and employees, and of “nonqualified” stock options to non-employee directors of the Company.  The 2007 Plan also provides for the potential issuance of restricted stock awards to these same classes of eligible participants, on such terms and conditions as are established at the discretion of the Board of Directors or the Compensation Committee.  The total number of shares of the Company’s authorized but unissued stock reserved and available for issuance pursuant to awards under the 2007 Plan was initially 1,500,000 shares, although options have been granted since the inception of the plan and the number remaining available for grant as of March 31, 2011 was 1,025,120.  No restricted stock awards have been issued by the Company.

Pursuant to FASB’s standards on stock compensation, share-based compensation expense is reflected in our income statement for each option granted over the vesting period of such option.  The Company is utilizing the Black-Scholes model to value stock options, and the “multiple option” approach is used to allocate the resulting valuation to actual expense.  Under the multiple option approach, an employee’s options for each vesting period are separately valued and amortized.  This appears to be the preferred method for option grants with multiple vesting periods, which is the case for most options granted by the Company.  A pre-tax charge of $65,000 was reflected in the Company’s income statement during the first quarter of 2011 and $38,000 was charged during the first quarter of 2010, as compensation expense related to outstanding and unvested stock options.

Note 6 – Earnings Per Share

Earnings per share, as presented in the Consolidated Statements of Income, is computed based on the weighted average number of shares outstanding during each period.  There were 13,981,780 weighted average shares outstanding during the first quarter of 2011, and 11,630,773 during the first quarter of 2010.  The increase is primarily due to the issuance of 2,325,000 shares pursuant to a registered direct offering in October 2010.

Diluted earnings per share include the effect of the potential issuance of common shares, which for the Company is limited to shares that would be issued on the exercise of outstanding “in-the-money” stock options. The dilutive effect of options outstanding was calculated using the treasury stock method, excluding anti-dilutive shares and adjusting for unamortized expense and windfall tax benefits. For the first quarter of 2011, the dilutive effect of options outstanding calculated under the treasury stock method totaled 78,881, which was added to basic weighted average shares outstanding for purposes of calculating diluted earnings per share. Likewise, for the first quarter of 2010, shares totaling 62,816 were added to basic weighted average shares outstanding in order to calculate diluted earnings per share.

Note 7 – Comprehensive Income

Comprehensive income includes net income and other comprehensive income. The Company’s only source of other comprehensive income is derived from unrealized gains and losses on available-for-sale investment securities. Reclassification adjustments, resulting from gains or losses on investment securities that were realized and included in net income of the current period that also had been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose, are excluded from comprehensive income of the current period. The Company’s comprehensive income was as follows:

 
6

 

Comprehensive Income
           
(dollars in thousands, unaudited)
 
For the Three-Month Period
 
   
Ended March 31,
 
   
2011
   
2010
 
             
Net Income
  $ 1,529     $ 2,339  
Other comprehensive income:
               
Unrealized holding gain
    1,839       1,184  
Less: reclassification adjustment
    -       -  
Pre-tax other comprehensive income/(loss)   
    1,839       1,184  
Less: tax impact of above
    773       498  
Net other comprehensive income
    1,066       686  
                 
Comprehensive income
  $ 2,595     $ 3,025  

Note 8 – Financial Instruments with Off-Balance-Sheet Risk

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business, in order to meet the financing needs of its customers. These financial instruments consist of commitments to extend credit and standby letters of credit. They involve, to varying degrees, elements of risk in excess of the amount recognized in the balance sheet. The Company’s exposure to credit loss in the event of nonperformance by the other party for commitments to extend credit and letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and issuing letters of credit as it does for making loans included on the balance sheet. The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):

   
March 31, 2011
   
December 31, 2010
 
Commitments to extend credit
  $ 140,749     $ 142,309  
Standby letters of credit
  $ 7,605     $ 7,761  
Commercial letters of credit
  $ 9,430     $ 9,435  

Commitments to extend credit consist primarily of unfunded single-family residential construction loans and home equity lines of credit, and commercial real estate construction loans and commercial revolving lines of credit. Construction loans are established under standard underwriting guidelines and policies and are secured by deeds of trust, with disbursements made over the course of construction. Commercial revolving lines of credit have a high degree of industry diversification. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. Standby letters of credit are generally unsecured and are issued by the Company to guarantee the performance of a customer to a third party, while commercial letters of credit represent the Company’s commitment to pay a third party on behalf of a customer upon fulfillment of contractual requirements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loans to customers.

Note 9 – Fair Value Disclosures and Reporting, the Fair Value Option and Fair Value Measurements

FASB’s standards on fair value measurements and disclosures, and financial instruments, require all entities to disclose the estimated fair value of all financial instruments for which it is practicable to estimate fair value. In addition to those footnote disclosure requirements, FASB’s standard on investments requires that our debt securities, which are classified as available for sale, and our equity securities that have readily determinable fair values, be measured and reported at fair value in our statement of financial position. Certain impaired loans are also reported at fair value, as explained in greater detail below, and foreclosed assets are carried at the lower of cost or fair value. While the fair value option outlined under FASB’s standard on financial instruments permits companies to report certain other financial assets and liabilities at fair value, we have not elected the fair value option for any additional financial assets or liabilities.

Fair value measurements and disclosure standards also establish a framework for measuring fair value.  Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability, in an orderly transaction between market participants on the measurement date.  Further, they establish a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value.  The standards describe three levels of inputs that may be used to measure fair value:

 
7

 

 
·
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.

 
·
Level 2: Significant observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

 
·
Level 3: Significant unobservable inputs that reflect a company’s own assumptions about the factors that market participants would consider in pricing an asset or liability.

Fair value estimates are made at a specific point in time based on relevant market data and information about the financial instruments.  These estimates do not reflect any premium or discount that could result from offering the Company’s entire holdings of a particular financial instrument for sale at one time, nor do they attempt to estimate the value of anticipated future business related to the instruments.  In addition, the tax ramifications related to the realization of unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in any estimates.  Because no market exists for a significant portion of the Company’s financial instruments, fair value disclosures are based on judgments regarding current economic conditions, risk characteristics of various financial instruments and other factors.  These estimates are subjective in nature and involve uncertainties and matters of significant judgment and therefore cannot be determined with precision.  Changes in assumptions could significantly affect the fair values presented.  The following methods and assumptions were used by the Company to estimate the fair value of its financial instruments disclosed at March 31, 2011 and December 31, 2010:

 
·
Cash and cash equivalents and short-term borrowings:  For cash and cash equivalents and short-term borrowings, the carrying amount is estimated to be fair value.

 
·
Investment securities:  The fair values of investment securities are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on the securities’ relationship to other benchmark quoted securities when quoted prices for the specific securities being valued are not readily available.

 
·
Loans and leases:  For variable-rate loans and leases that re-price frequently with no significant change in credit risk or interest rate spread, fair values are based on carrying values.  Fair values for other loans and leases are estimated by discounting projected cash flows at interest rates being offered at each reporting date for loans and leases with similar terms to borrowers of comparable creditworthiness.  Fair values of loans held for sale are estimated using quoted market prices for similar loans or the amount the purchasers have committed to purchase the loan.  The carrying amount of accrued interest receivable approximates its fair value.

 
·
Cash surrender value of life insurance policies:  The fair values are based on current cash surrender values at each reporting date provided by the insurers.

 
·
Investment in, and capital commitments to, limited partnerships:  The fair values of our investments in WNC Institutional Tax Credit Fund Limited Partnerships and any other limited partnerships are estimated using quarterly indications of value provided by the general partner.  The fair values of undisbursed capital commitments are assumed to be the same as their book values.

 
·
Other investments:  Included in other assets are certain long-term investments carried at cost, which approximates their estimated fair value.

 
8

 

 
·
Deposits:  The fair values for demand deposits and other non-maturity deposits are, by definition, equal to the amount payable on demand at the reporting date represented by their carrying amount.  Fair values for fixed-rate certificates of deposit are estimated using a cash flow analysis, discounted at interest rates being offered at each reporting date by the Bank for certificates with similar remaining maturities.  The carrying amount of accrued interest payable approximates its fair value.

 
·
Short-term borrowings:  The carrying amounts of federal funds purchased, overnight FHLB advances, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days approximate their fair values.  Fair values of other short-term borrowings are estimated by discounting projected cash flows at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 
·
Long-term borrowings:  The fair values of the Company’s long-term borrowings are estimated using projected cash flow analyses discounted at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 
·
Subordinated debentures:  The fair value of subordinated debentures was determined based on the current market value for like kind instruments of a similar maturity and structure.

 
·
Commitments to extend credit and letters of credit:  Commitments to extend credit are primarily for adjustable rate loans.  Commitments to fund fixed rate loans and letters of credit, where such exist, are also at rates which approximate market rates at each reporting date.  Thus, if funded, the carrying amounts would approximate fair values for the newly created financial assets at the funding date.  However, because of the high degree of uncertainty with regard to whether or not these commitments will ultimately be funded, fair values for loan commitments and letters of credit in their current undisbursed state cannot reasonably be estimated, and only notional values are disclosed in the table below.

Estimated fair values for the Company’s financial instruments at March 31, 2011 and December 31, 2010 are as follows:

Fair Value of Financial Instruments
                       
(dollars in thousands, unaudited)
 
March 31, 2011
   
December 31, 2010
 
   
Carrying Amount
   
Fair Value
   
Carrying Amount
   
Fair Value
 
Financial assets:
                       
Cash and due from banks
  57,522     $ 57,522     $ 42,645     $ 42,645  
Investment securities available for sale
  375,027     $ 375,027     $ 331,730     $ 331,730  
Loans and leases, net
  755,116     $ 782,173     $ 784,515     $ 816,185  
Cash surrender value of life ins. policies
  $ 32,010     $ 32,010     $ 31,591     $ 31,591  
Other investments
  $ 8,045     $ 8,045     $ 8,361     $ 8,361  
Investments in limited partnerships
  $ 10,525     $ 10,525     $ 10,899     $ 10,899  
Accrued interest receivable
  $ 5,425     $ 5,425     $ 5,677     $ 5,677  
                                 
Financial liabilities:
                               
Deposits
  $ 1,091,705     $ 1,092,047     $ 1,052,274     $ 1,052,085  
Overnight borrowings
  $ 5,000     $ 5,000     $ 14,650     $ 14,650  
Term borrowings
  $ 10,000     $ 10,604     $ 15,000     $ 15,736  
Subordinated debentures
  $ 30,928     $ 11,685     $ 30,928     $ 11,610  
Limited partnership capital commitment
  $ 599     $ 764     $ 417     $ 417  
Accrued interest payable
  $ 523     $ 523     $ 678     $ 678  
                                 
   
Notional Amount
           
Notional Amount
         
Off-balance-sheet financial instruments:
                               
Commitments to extend credit
  $ 140,749             $ 142,309          
Standby letters of credit
  $ 7,605             $ 7,761          
Commercial letters of credit
  $ 9,430             $ 9,435          

For each category of financial assets that were actually reported at fair value at March 31, 2011, the Company used the following methods and significant assumptions:

 
9

 
 
 
·
Investment Securities:  The fair values of trading securities and securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges or by matrix pricing, which is a mathematical technique used widely in the industry to value debt securities by relying on the their relationship to other benchmark quoted securities.

 
·
Loans held for sale:  Since loans designated by the Company as available-for-sale are typically sold shortly after making the decision to sell them, realized gains or losses are usually recognized within the same period and fluctuations in fair values are thus not relevant for reporting purposes.  If available for sale loans stay on our books for an extended period of time, the fair value of those loans is determined using quoted secondary-market prices.

 
·
Impaired loans:  Impaired loans carried at fair value are those for which it is probable that the bank will be unable to collect all amounts due (including both interest and principal) according to the original contractual terms of the loan agreement, and for which the carrying value has been written down to the fair value of the loan.  The carrying value of those loans is equivalent to the fair value of the collateral, net of expected disposition costs, for collateral-dependent loans, or the present value of anticipated future cash flows.

 
·
Foreclosed assets:  Repossessed real estate (OREO) and other assets are carried at the lower of cost or fair value.  For those carried at fair value, fair value is appraised value less expected selling costs for OREO and some other assets such as mobile homes, and estimated sales proceeds as determined by using reasonably available sources for all other assets.  Foreclosed assets for which appraisals can be feasibly obtained are periodically measured for impairment using updated appraisals.  Other foreclosed assets are periodically re-evaluated by adjusting expected cash flows and timing of resolution, again using reasonably available sources.  If impairment is determined to exist, the book value of a foreclosed asset is immediately written down to its estimated impaired value through the income statement, thus the carrying amount is equal to the fair value and there is no valuation allowance.
 
Assets reported at fair value on a recurring basis are summarized below:

 
10

 
 
Fair Value Measurements - Recurring                        
(dollars in thousands, unaudited)
                       
   
Fair Value Measurements at March 31, 2011, Using
 
 
 
Level 1
   
Level 2
   
Level 3
   
Total
 
Investment Securities                                 
U.S. Government agencies
  $ -     $ 4,970     $ -     $ 4,970  
Obligations of states and political subdivisions
    -       72,917       -       72,917  
U.S. Government agencies collateralized by mortgage obligations
    -       295,582       -       295,582  
Other Securities
    1,558       -       -       1,558  
Total availabe-for-sale securities
    1,558       373,469       -       375,027  
                                 
Loans Held for Sale
    44       -       -       44  
Total
  $ 1,602     $ 373,469     $ -     $ 375,071  
                                 
   
Fair Value Measurements at December 31, 2010, Using
 
 
 
Level 1
   
Level 2
   
Level 3
   
Total
 
Investment Securities                                 
U.S. Government agencies
  $ -     $ 5,062     $ -     $ 5,062  
Obligations of states and political subdivisions
    -       70,102       -       70,102  
U.S. Government agencies collateralized by mortgage obligations
    -       255,143       -       255,143  
Other Securities
    1,423       -       -       1,423  
Total availabe-for-sale securities
    1,423       330,307       -       331,730  
                                 
Loans Held for Sale
    914       -       -       914  
Total
  $ 2,337     $ 330,307     $ -     $ 332,644  

Assets for which a nonrecurring change in fair value has been recorded are summarized below:

Fair Value Measurements - Nonrecurring                        
(dollars in thousands, unaudited)
                       
   
Fair Value Measurements at March 31, 2011, Using
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Impaired Loans
  $ -     $ 31,812     $ 11,476     $ 43,288  
Foreclosed Assets
  $ -     $ 15,310     $ 3,904     $ 19,214  
                                 
   
Fair Value Measurements at December 31, 2010, Using
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
Impaired Loans
  $ -     $ 29,482     $ 6,705     $ 36,187  
Foreclosed Assets
  $ -     $ 3,123     $ 17,568     $ 20,691  

The table above only includes impaired loan balances for which a specific reserve has been established or on which a write-down has been taken.  Information on the Company’s total impaired loan balances, and specific loss reserves associated with those balances, is included in Management’s Discussion and Analysis of Financial Condition and Results of Operation, in the “Credit Quality and Nonperforming Assets” and “Allowance for Loan and Lease Losses” sections.

 
11

 

PART I - FINANCIAL INFORMATION
 
ITEM 2
 
MANAGEMENT’S DISCUSSION AND
ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This Form 10-Q includes forward-looking statements that involve inherent risks and uncertainties.  Words such as “expects”, “anticipates”, “believes”, “projects”, and “estimates” or variations of such words and similar expressions are intended to identify forward-looking statements.  These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict.  Therefore, actual outcomes and results may differ materially from what is expressed, forecast in, or implied by such forward-looking statements.

A variety of factors could have a material adverse impact on the Company’s financial condition or results of operations, and should be considered when evaluating the potential future financial performance of the Company.  These include, but are not limited to, continued deterioration in economic conditions in the Company’s service areas; risks associated with fluctuations in interest rates; liquidity risks; increases in nonperforming assets and net credit losses that could occur, particularly in times of weak economic conditions or rising interest rates; the Company’s ability to secure buyers for foreclosed properties; the loss in market value of available-for-sale securities that could result if interest rates change substantially or an issuer has real or perceived financial difficulties; the Company’s ability to attract and retain skilled employees; the Company’s ability to successfully deploy new technology; the success of branch expansion; and risks associated with the multitude of current and future laws and regulations to which the Company is and will be subject.

CRITICAL ACCOUNTING POLICIES

The Company’s financial statements are prepared in accordance with accounting principles generally accepted in the United States.  The financial information and disclosures contained within those statements are significantly impacted by Management’s estimates and judgments, which are based on historical experience and various other assumptions that are believed to be reasonable under current circumstances.  Actual results may differ from those estimates under divergent conditions.

Critical accounting policies are those that involve the most complex and subjective decisions and assessments, and have the greatest potential impact on the Company’s stated results of operations.  In Management’s opinion, the Company’s critical accounting policies deal with the following areas:  the establishment of the Company’s allowance for loan and lease losses, as explained in detail in the “Provision for Loan and Lease Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; the valuation of nonperforming real estate loans and foreclosed assets; income taxes, especially with regard to the ability of the Company to recover deferred tax assets, as discussed in the “Provision for Income Taxes” and “Other Assets” sections of this discussion and analysis; goodwill, which is evaluated annually for impairment based on the fair value of the Company and for which it has been determined that no impairment exists; and equity-based compensation, which is discussed in greater detail in Note 5 to the consolidated financial statements.  Critical accounting areas are evaluated on an ongoing basis to ensure that the Company’s financial statements incorporate the most recent expectations with regard to these areas.

 
12

 


OVERVIEW OF THE RESULTS OF OPERATIONS
AND FINANCIAL CONDITION

RESULTS OF OPERATIONS SUMMARY

First Quarter 2011 compared to First Quarter 2010
 
Net income for the quarter ended March 31, 2011 was $1.529 million, representing a decline of $810,000, or 35%, relative to net income of $2.339 million for the quarter ended March 31, 2010.  The 52% drop in pretax income was proportionally greater than the decline in net income, because an income tax accrual reversal of $279,000 helped boost net income in the first quarter of 2011.  Basic and diluted earnings per share for the first quarter of 2011 were $0.11, compared to $0.20 basic and diluted earnings per share for the first quarter of 2010.  The Company’s annualized return on average equity was 3.86% and annualized return on average assets was 0.48% for the quarter ended March 31, 2011, compared to a return on equity of 6.97% and return on assets of 0.72% for the quarter ended March 31, 2010.  The primary drivers behind the variance in net income are as follows:

·
Net interest income was down $1.324 million, or 9%, due to a decline in average interest-earning assets of $38 million, or 3%, and a 29 basis point drop in our net interest margin.  Negative factors impacting our net interest margin in 2011 include lower real estate loan yields resulting from increased competition for quality loans, a shift from average loan balances into lower-yielding investment balances, and a higher average balance of non-interest earning assets.

·
The Company’s loan loss provision increased by $200,000, or 6%.  Thus far in 2011, our loan loss provision has been utilized to provide specific reserves for impaired loans and to replenish reserves subsequent to loan charge-offs.  Net loans charged off totaled $3.3 million in the first quarter of 2011 relative to $3.0 million in the first quarter of 2010.

·
Total non-interest revenue declined by $285,000, or 7%, due to a drop in overdraft income resulting from procedural changes implemented pursuant to regulatory guidance.  The decline in overdraft income was partially offset by an increase in debit card interchange fees.

·
Total operating expense fell by $471,000, or 4%.  Salaries and benefits fell slightly for the quarter despite the addition of staff for newer branches, due primarily to our efforts to improve operating efficiencies.  The major variances in operating expense include the following:  Occupancy expense declined by $165,000, or 9%, due a drop in depreciation expense and lower maintenance/repair costs, as well as the January 2011 closure of a branch with a relatively costly lease; marketing costs declined $100,000 due mainly to the timing of payments; and data processing expenses were down $107,000, due to vendor credits for overcharges on processing software in previous years.

·
As noted above, the Company experienced an income tax accrual reversal of $279,000 in the first quarter of 2011 due to a high level of tax credits available relative to taxable income.  The tax credits have a greater impact than might otherwise be expected due to the favorable effect of tax-exempt interest income and BOLI income when determining taxable income.  In contrast to the negative tax provision in the first quarter of 2011, our effective tax accrual rate was 10% in the first quarter of 2010.

FINANCIAL CONDITION SUMMARY

March 31, 2011 relative to December 31, 2010
 
The most significant characteristics of, and changes in, the Company’s balance sheet during the first three months of 2011 are outlined below:

·
The Company’s assets totaled $1.313 billion at March 31, 2011, an increase of $26 million, or 2%, relative to total assets of $1.287 billion at December 31, 2010.  Total assets increased due to growth in investment securities and an increase in cash and balances due from banks, partially offset by lower loan balances.  Gross loan and lease balances declined $29 million, or 4%, due to runoff in the normal course of business, prepayments, transfers to OREO, and charge-offs.  Weak loan demand from quality borrowers and aggressive competition have hindered our ability to counteract this contraction.

 
13

 



·
The $73 million balance of nonperforming assets at March 31, 2011 reflects an increase of $6 million, or 9%, since year-end 2010, but is still below its peak of $78 million reached a year earlier.  Much of the increase for the first quarter consists of a $3.6 million participation purchased in a commercial real estate loan, which was placed on non-accrual status but for which no reserve is currently required based on the appraised value of the collateral.  In addition to nonperforming assets we had $12.6 million in performing restructured troubled debt (TDR’s) at March 31, 2011, an increase of only $86,000 relative to year-end 2010.

·
Our allowance for loan and lease losses was $21.5 million as of March 31, 2011, which represents a slight increase relative to the balance at December 31, 2010.  Even though the allowance for loan and lease losses did not change significantly, our allowance as a percentage of total loans increased by 14 basis points, to 2.76% at March 31, 2011 from 2.62% at December 31, 2010, because loan balances fell during the first quarter.

·
Total deposits increased by $39 million, or 4%, with non-maturity deposits, in particular, experiencing significant growth.  NOW deposits, however, dropped by $10 million, or 5%, due to runoff in our online-only accounts subsequent to interest rate adjustments.  We reduced non-deposit borrowings by $15 million, but added $15 million in longer-term wholesale-sourced brokered deposits for interest rate risk management purposes.

·
Total capital increased by $2 million, to $162 million at March 31, 2011.  Because capital increased and risk-adjusted assets declined, our consolidated total risk-based capital ratio increased to 21.20% at March 31, 2011 from 20.33% at year-end 2010.  Further, our tier one risk-based capital ratio was 19.94% and our tier one leverage ratio was 14.11% at March 31, 2011.

EARNINGS PERFORMANCE

The Company earns income from two primary sources.  The first is net interest income, which is interest income generated by earning assets less interest expense on interest-bearing liabilities.  The second is non-interest income, which consists mainly of customer service charges and fees but also comes from non-customer sources such as bank-owned life insurance.  The majority of the Company’s non-interest expenses are operating costs that relate to providing a full range of banking services to our customers.

NET INTEREST INCOME AND NET INTEREST MARGIN

For the first quarter of 2011 relative to the first quarter of 2010, net interest income declined by $1.324 million, or 9%.  The level of net interest income depends on several factors in combination, including growth in earning assets, yields on earning assets, the cost of interest-bearing liabilities, the relative volume of earning assets and interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities.  Net interest income can also be impacted by the reversal of interest for loans placed on non-accrual, and by the recovery of interest on loans that have been on non-accrual and are either sold or returned to accrual status.

The following Average Balances and Rates table shows the average balance of each significant balance sheet category, and the amount of interest income or interest expense associated with that category, for the comparative quarters.  The table also shows the calculated yields on each major component of the Company’s investment and loan portfolio, the average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin.

 
14

 

Average Balances and Rates
 
For the Quarter
   
For the Quarter
 
(dollars in thousands, except per share data)
 
Ended March 31, 2011 (1) (2) (3)
   
Ended March 31, 2010 (1) (2) (3)
 
   
Average
   
Income/
   
Average
   
Average
   
Income/
   
Average
 
   
Balance
   
Expense
   
Rate/Yield
   
Balance
   
Expense
   
Rate/Yield
 
Assets
                                   
Investments:
                                   
Federal funds sold/Due from time
  $ 10,326     $ 8       0.31 %   $ 22,107     $ 17       0.31 %
Taxable
    276,740       1,916       2.81 %     221,884       2,108       3.85 %
Non-taxable
    71,814       716       6.22 %     64,280       644       6.25 %
Equity
    1,549       -       0.00 %     1,519       -       0.00 %
Total Investments
    360,429       2,640       3.40 %     309,790       2,769       4.08 %
                                                 
Loans and Leases: (4) (5)
                                               
Agricultural
    12,088       152       5.10 %     9,672       120       5.03 %
Commercial
    102,185       1,522       6.04 %     119,125       1,754       5.97 %
Real Estate
    569,672       9,049       6.44 %     626,876       10,408       6.73 %
Consumer
    44,082       944       8.68 %     54,713       1,123       8.32 %
Direct Financing Leases
    7,948       115       5.87 %     12,183       173       5.76 %
Other
    49,730       -       0.00 %     51,661       -       0.00 %
Total Loans and Leases
    785,705       11,782       6.08 %     874,230       13,578       6.30 %
Total Interest Earning Assets (5)
    1,146,134       14,422       5.24 %     1,184,020       16,347       5.72 %
Other Earning Assets
    8,347                       9,361                  
Non-Earning Assets
    138,694                       127,584                  
Total Assets
  $ 1,293,175                     $ 1,320,965                  
                                                 
Liabilities and Shareholders' Equity
                                               
Interest Bearing Deposits:
                                               
NOW
  $ 177,104     $ 215       0.49 %   $ 160,549     $ 384       0.97 %
Savings Accounts
    78,182       46       0.24 %     65,090       36       0.22 %
Money Market
    156,491       190       0.49 %     175,332       252       0.58 %
CDAR's
    32,762       54       0.67 %     114,247       263       0.93 %
Certificates of Deposit < $100,000
    161,388       274       0.69 %     144,595       320       0.90 %
Certificates of Deposit $100,000
    191,285       287       0.61 %     194,305       306       0.64 %
Brokered Deposits
    6,833       25       1.48 %     21,200       97       1.86 %
Total Interest Bearing Deposits
    804,045       1,091       0.55 %     875,318       1,658       0.77 %
Borrowed Funds:
                                               
Federal Funds Purchased
    3       -       0.00 %     3       -       0.00 %
Repurchase Agreements
    -       -       0.00 %     -       -       0.00 %
Short Term Borrowings
    5,103       34       2.70 %     9,396       38       1.64 %
Long Term Borrowings
    15,000       140       3.79 %     19,222       176       3.71 %
TRUPS
    30,928       181       2.37 %     30,928       175       2.29 %
Total Borrowed Funds
    51,034       355       2.82 %     59,549       389       2.65 %
Total Interest Bearing Liabilities
    855,079       1,446       0.69 %     934,867       2,047       0.89 %
Demand Deposits
    261,801                       237,609                  
Other Liabilities
    15,489                       12,454                  
Shareholders' Equity
    160,806                       136,035                  
Total Liabilities and Shareholders' Equity
  $ 1,293,175                     $ 1,320,965                  
                                                 
Interest Income/Interest Earning Assets
                    5.24 %                     5.72 %
Interest Expense/Interest Earning Assets
                    0.51 %                     0.70 %
Net Interest Income and Margin (6)
          $ 12,976       4.73 %           $ 14,300       5.02 %

(1)
Average balances are obtained from the best available daily or monthly data and are net of deferred fees and related direct costs.
(2)
Yields and net interest margin have been computed on a tax equivalent basis using an effective tax rate of 35%.
(3)
Annualized
(4)
Net loan costs have been included in the calculation of interest income.  Net loan costs were approximately $193 thousand and $39 thousand for the quarters ended March 31, 2011 and 2010. Loans are gross of the allowance for possible loan losses.
(5)
Non-accrual loans have been included in total loans for purposes of total earning assets.
(6)
Represents net interest income as a percentage of average interest-earning assets.

 
15

 


The Volume and Rate Variances table below sets forth the dollar difference in interest earned or paid for each major category of interest-earning assets and interest-bearing liabilities for the noted periods, and the amount of such change attributable to changes in average balances (volume) or changes in average interest rates.  Volume variances are equal to the increase or decrease in average balance multiplied by prior period rates, and rate variances are equal to the increase or decrease in rate times prior period average balances.  Variances attributable to both rate and volume changes are calculated by multiplying the change in rate by the change in average balance, and have been allocated to the rate variance.

Volume & Rate Variances
 
Quarter Ended March 31,
 
(dollars in thousands)
 
2011 over 2010
 
   
Increase (decrease) due to
 
 
 
Volume
   
Rate
   
Net
 
Assets:                  
Investments:
                 
Federal funds sold / Due from time
  $ (9 )   $ -     $ (9 )
Taxable
    521       (713 )     (192 )
Non-taxable (1)
    75       (3 )     72  
Equity
    0       0       0  
Total Investments
    587       (716 )     (129 )
Loans and Leases:
                       
Agricultural
    30       2       32  
Commercial
    (249 )     17       (232 )
Real Estate
    (950 )     (409 )     (1,359 )
Consumer
    (218 )     39       (179 )
Direct Financing Leases
    (60 )     2       (58 )
Other
    0       0       0  
Total Loans and Leases
    (1,447 )     (349 )     (1,796 )
Total Interest Earning Assets
    (860 )     (1,065 )     (1,925 )
Liabilities
                       
Interest Bearing Deposits:
                       
NOW
    40       (209 )     (169 )
Savings Accounts
    7       3       10  
Money Market
    (27 )     (35 )     (62 )
CDAR's
    (188 )     (21 )     (209 )
Certificates of Deposit < $100,000
    37       (83 )     (46 )
Certificates of Deposit $100,000
    (5 )     (14 )     (19 )
Brokered Deposits
    (66 )     (6 )     (72 )
Total Interest Bearing Deposits
    (202 )     (365 )     (567 )
Borrowed Funds:
                       
Federal Funds Purchased
    0       0       0  
Repurchase Agreements
    0       0       0  
Short Term Borrowings
    (17 )     13       (4 )
Long Term Borrowings
    (39 )     3       (36 )
TRUPS
    0       6       6  
Total Borrowed Funds
    (56 )     22       (34 )
Total Interest Bearing Liabilities
    (258 )     (343 )     (601 )
Net Interest Margin/Income
  $ (602 )   $ (722 )   $ (1,324 )

(1) Yields on tax exempt income have not been computed on a tax equivalent basis.

As shown above, the volume variance for the first quarter of 2011 relative to the first quarter of 2010 was negative $602,000, due primarily to the fact that average interest-earning assets were $38 million lower in the first quarter of 2011.  The negative volume variance was exacerbated by balance movement within assets, where we experienced an $89 million drop in average loans due to declining balances of relatively high-yielding real estate, commercial and consumer loans, and a $51 million increase in the average balance of investments, which have significantly lower yields.  Furthermore, the average balance of non-earning assets was $11 million higher, due mainly to an increase in the average balance of cash and due from banks and a higher deferred tax asset balance.  The unfavorable shift in average asset balances was partially offset by favorable changes on the liability side, where we experienced movement out of CDARS, brokered deposits, and wholesale borrowings into lower-cost core deposits.  An increase in average equity, resulting from our registered direct offering in October 2010 and the addition of net income, also helped reduced our reliance on interest-bearing liabilities and thus helped limit the magnitude of the negative volume variance.

 
16

 

The rate variance was also negative for the quarter, contributing $722,000 to the drop in net interest income.  There hasn’t been a significant change in market interest rates during the past year, but our weighted average yield on interest-earning assets was 48 basis points lower due to the addition of investment securities in a relatively low-rate environment, and lower real estate loan yields, which declined 29 basis points due to increased competition for quality loans.  The negative rate variance is exacerbated by our sizeable net interest position, which is the difference between interest-earning assets and interest-bearing liabilities.  Our average net interest position for the first quarter of 2010, which is the base period for the rate variance calculation, was $249 million, meaning that the yield decrease for interest-earning assets was applied to a much higher balance than the rate decrease for interest-bearing liabilities and had a greater impact on net interest income.  Factors partially offsetting the negative pressures on our rate variance include a drop in our weighted average cost of interest-bearing liabilities, which was 20 basis points lower due primarily to an improving deposit mix and the easing of competitive pressures on time deposit rates.  Net interest reversals totaled only $27,000 in the first quarter of 2011 relative to $285,000 in the first quarter of 2010, which also helped partially offset the negative factors.

The Company’s net interest margin, which is tax-equivalent net interest income as a percentage of average interest-earning assets, is affected by the same factors discussed above relative to rate and volume variances.  Our net interest margin was 4.73% in the first quarter of 2011, a decline of 29 basis points relative to the first quarter of 2010.  Negative factors impacting our net interest margin in 2011 include lower real estate loan yields, a shift from average loan balances into lower-yielding investment balances, and higher average balances for non-interest earning assets.  Having a favorable impact on our net interest margin were a lower level of net interest reversals, a shift in average balances from higher-cost liabilities into lower-cost core deposits, and a reduced reliance on interest-bearing liabilities.  We expect that our net interest margin could continue to experience slight contraction due to heightened competitive pressures on loan yields, and that effect will be intensified if we are unable to reverse the unfavorable trend in loan balances.

PROVISION FOR LOAN AND LEASE LOSSES

Credit risk is inherent in the business of making loans.  The Company sets aside an allowance for loan and lease losses through periodic charges to earnings, which are reflected in the income statement as the provision for loan losses.  Those charges are in amounts sufficient to achieve an allowance for loan and lease losses that, in management’s judgment, is adequate to absorb probable loan losses related to specifically-identified impaired loans, as well as probable incurred loan losses in the remaining loan portfolio.

The Company’s provision for loan losses increased by $200,000, or 6%, in the first quarter of 2011 relative to the first quarter of 2010.  The loan loss provision typically includes reserve replenishment subsequent to loan charge-offs, as well as the enhancement of general reserves for performing loans and specific reserves for impaired loans as needed pursuant to a detailed analysis of the adequacy our allowance for loan and lease losses.  Thus far in 2011, our loan loss provision has been utilized primarily to provide specific reserves for impaired loans and to replenish reserves subsequent to loan charge-offs.  Much of the increase in specific reserves was centered in a few large loans, where updated appraisals indicated deterioration in underlying collateral values.  Balances transferred to non-accrual status totaled $15 million for the first quarter of 2011, and net loans charged off during the same period totaled $3.3 million relative to $3.0 million in the first quarter of 2010.  The Company’s policies for monitoring the adequacy of the allowance and determining loan amounts that should be charged off, and other detailed information with regard to changes in the allowance, are discussed below in “Allowance for Loan and Lease Losses.”

NON-INTEREST REVENUE AND OPERATING EXPENSE

The following table provides details on the Company’s non-interest income and operating expense for the first quarter of 2011 relative to the first quarter of 2010:

 
17

 
 
Non Interest Income/Expense
                       
(dollars in thousands, unaudited)
 
For the Quarter
 
   
Ended March 31,
 
 
 
2011
   
% of
Total
   
2010
   
% of
Total
 
OTHER OPERATING INCOME:                                
Service charges on deposit accounts
  $ 2,255       63.06 %   $ 2,703       70.01 %
Other service charges, commissions & fees
    906       25.33 %     830       21.50 %
Gains on sales of loans
    43       1.20 %     24       0.62 %
Gains on securities
    -       0.00 %     -       0.00 %
Loan servicing income
    6       0.17 %     9       0.23 %
Bank owned life insurance
    374       10.46 %     370       9.58 %
Other
    (8 )     -0.22 %     (75 )     -1.94 %
Total non-interest income
    3,576       100.00 %     3,861       100.00 %
As a % of average interest-earning assets (1)
            1.27 %             1.32 %
                                 
OTHER OPERATING EXPENSES:
                               
Salaries and Employee Benefits
    5,710       48.80 %     5,779       47.47 %
Occupancy costs
                               
Furniture & equipment
    521       4.45 %     668       5.49 %
Premises
    1,054       9.01 %     1,072       8.80 %
Advertising and marketing costs
    422       3.61 %     522       4.29 %
Data processing costs
    273       2.33 %     380       3.12 %
Deposit services costs
    637       5.44 %     684       5.62 %
Loan services costs
                               
Loan processing
    226       1.93 %     140       1.15 %
Foreclosed assets
    624       5.33 %     639       5.25 %
Credit card 
    -       0.00 %     -       0.00 %
Other operating costs
                               
Telephone & data communications
    295       2.52 %     282       2.32 %
Postage & mail
    141       1.21 %     142       1.17 %
Other
    230       1.97 %     241       1.98 %
Professional services costs
                               
Legal & accounting
    382       3.26 %     336       2.76 %
Other professional service
    933       7.97 %     969       7.96 %
Stationery & supply costs
    172       1.47 %     212       1.74 %
Sundry & tellers
    82       0.70 %     107       0.88 %
Total non-interest Expense
  $ 11,702       100.00 %   $ 12,173       100.00 %
As a % of average interest-earning assets (1)
            4.14 %             4.17 %
Efficiency Ratio (2)
    68.13 %             64.66 %        

(1) Annualized
(2) Tax Equivalent

The Company’s results reflect total non-interest income of $3.576 million in the first quarter of 2011, a decline of $285,000, or 7%, relative to the first quarter of 2010. The decline is centered in service charges on deposits, but the drop in service charges was partially offset by higher debit card interchange fees and a lower level of losses realized on the termination of operating leases. Total other operating income was an annualized 1.27% of average interest-earning assets in the first quarter of 2011, relative to 1.32% in the first quarter of 2010.

Service charge income on deposits declined by $448,000, or 17%, in the first quarter of 2011 relative to the first quarter of 2010, and fell to 0.51% of average transaction account balances in the first quarter of 2011 from 0.68% in the first quarter of 2010. This decline is due to a $495,000 drop in overdraft and returned item charges, which is primarily the result of procedural changes implemented pursuant to new consumer legislation and updated regulatory guidelines on overdrafts. Other service charges, commissions, and fees increased by $76,000, or 9%, for the quarter, due mainly to an increase of $114,000 in debit card point-of-sale interchange fees that was partially offset by declining income on operating leases. Debit card interchange fees are higher due to an increase in the number of active cards outstanding and increased per-card usage. Loan sale and servicing income remained at minimal levels in 2011 and 2010.

 
18

 

Bank-owned life insurance income increased very slightly, by $4,000, or 1%, in the first quarter of 2011 relative to the first quarter of 2010.  The Company owns and derives income from two basic types of BOLI :  “general account,” and “separate account.”  At March 31, 2011, the Company had $29.2 million invested in single-premium general account BOLI.  Income from our general account BOLI is used to fund expenses associated with executive salary continuation plans and director retirement plans, and is typically fairly consistent with interest credit rates that do not change frequently.  In addition to general account BOLI, the Company had $2.9 million invested in separate account BOLI at March 31, 2011, the earnings on which help offset deferred compensation accruals for certain directors and senior officers.  These deferred compensation BOLI accounts have returns pegged to participant-directed investment allocations which can include equity, bond, or real estate indices, and are thus subject to gains or losses.  While this often results in significant fluctuations in income from quarter to quarter, net gains on separate account BOLI totaled $124,000 in the first quarter of 2011 relative to net gains of $112,000 in the first quarter of 2010, an immaterial difference.  Gains and losses on separate account BOLI are related to participant gains and losses on deferred compensation balances.  Participant gains are accounted for as expense accruals which, combined with their associated tax effect, effectively offset income on separate account BOLI, while participant losses result in expense accrual reversals that also effectively offset losses on separate account BOLI.

The “Other” category under non-interest income includes gains and losses on the disposition of real properties and other assets, and rental income generated by the Company’s alliance with Investment Centers of America (ICA).  Other non-interest income was up by $67,000 in the first quarter of 2011 in comparison to the first quarter of 2010, due in large part to a $52,000 decline in losses incurred upon the disposition of equipment that was acquired subsequent to the termination of operating leases.  Also helping out for the first quarter of 2011 was the realization of $18,000 in net gains from the sale of OREO, relative to net losses of $10,000 in the first quarter of 2010.

Total operating expense (non-interest expense) was $11.702 million for the quarter ended March 31, 2011, a decline of $471,000, or 4%, relative to total operating expense for the same period in 2010.  The decline is primarily due to lower occupancy costs, advertising and marketing costs, and data processing costs.  Non-interest expense fell slightly to an annualized 4.14% of average interest-earning assets for the first quarter of 2011 from 4.17% in the first quarter of 2010.

The largest component of non-interest expense, salaries and employee benefits, dropped by $69,000, or 1%, for the comparative quarters.  This decline came in spite of additional staffing costs for our newer branches opened in February 2011 and March 2010, as we have been striving to improve operating efficiencies.  Partially offsetting the reduction was a $66,000 decline in salaries relating to successful loan originations in the first quarter of 2011 compared to the first quarter of 2010, due to lower loan origination activity.  Since this portion of salaries is deferred and amortized against interest income it has the effect of reducing current-period expense, hence a lower deferral equates to higher salaries expense.  Despite their dollar decline, salaries and benefits increased to 48.80% of total non-interest expense for the first quarter of 2011 from 47.47% in the first quarter of 2010, due simply to the fact that certain other expense categories declined by even greater amounts.

Occupancy expense dropped by $165,000, or 9%, for the quarter, due mainly to a drop in depreciation expense and lower maintenance/repair costs, although the January 2011 closure of a branch with a relatively costly lease also contributed to the decline.  Marketing costs also declined by $100,000, or 19%, although the drop was due to the timing of payments and does not represent a permanent decline.  Data processing costs were down as well, decreasing by $107,000, or 28%, for the quarter, due to vendor credits for overcharges on processing software in previous years.  Deposit services costs declined by $47,000, or 7%, due primarily to lower costs associated with our online checking product.  Loan processing costs rose by $86,000, or 61%, for the quarter, due primarily to increases in costs related to appraisals and collections.  Foreclosed asset costs declined by only $15,000, or 2%, but there were significant changes in the two largest components within this category:  OREO write-downs totaled $458,000 in the first quarter of 2011 relative to $267,000 in the first quarter of 2010, and foreclosed asset operating expenses totaled $166,000 in the first quarter of 2011 as compared to $371,000 in the first quarter of 2010.  Changes in other operating expenses were primarily caused by fluctuations in the timing of payments.

Because income fell by a relatively greater amount than non-interest expense, the Company’s tax-equivalent overhead efficiency ratio increased to 68.13% in the first quarter of 2011 from 64.66% in the first quarter of 2010.  The overhead efficiency ratio represents total operating expense divided by the sum of fully tax-equivalent net interest and non-interest income, with the provision for loan losses, investment gains/losses, and other extraordinary gains/losses excluded from the equation.

 
19

 

PROVISION FOR INCOME TAXES

The Company sets aside a provision for income taxes on a monthly basis.  The amount of the tax provision is determined by applying the Company’s statutory income tax rates to pre-tax book income, adjusted for permanent differences between pre-tax book income and actual taxable income.  Such permanent differences include but are not limited to tax-exempt interest income, increases in the cash surrender value of BOLI, California Enterprise Zone deductions, certain expenses that are not allowed as tax deductions, and tax credits.  The Company’s tax credits consist primarily of those generated by our $9.9 million investment in low-income housing tax credit funds, and California state employment tax credits.  The Company had a negative income tax provision of $279,000 in the first quarter of 2011, which helped boost income, relative to a tax accrual of $249,000 in the first quarter of 2010.  The tax accrual reversal for the first quarter of 2011 is the result of a relatively high level of tax credits, which had a greater impact than might be expected due to the favorable effect of tax-exempt interest income and BOLI income on pre-tax income.  Our tax credits stem from investments in low-income housing tax credit funds, as well as hiring tax credits.  Our tax accrual rate is currently very sensitive to changes in pretax income, because of our level of permanent differences relative to pretax income.

BALANCE SHEET ANALYSIS
   
EARNING ASSETS

INVESTMENTS

The major components of the Company’s earning asset base are its investments and loans, and the detailed composition and growth characteristics of both are significant determinants of the financial condition of the Company.  The Company’s investments are analyzed in this section, while the loan and lease portfolio is discussed in a later section of this Form 10-Q.

The Company’s investments consist of debt and marketable equity securities (together, the “investment portfolio”), investments in the time deposits of other banks, and overnight fed funds sold.  Fed funds sold represent the investment of temporary excess liquidity with one or more correspondent banks.  The Company’s investments serve several purposes:  1) they provide liquidity to even out cash flows from the loan and deposit activities of customers; 2) they provide a source of pledged assets for securing public deposits, bankruptcy deposits and certain borrowed funds which require collateral; 3) they constitute a large base of assets with maturity and interest rate characteristics that can be changed more readily than the loan portfolio, to better match changes in the deposit base and other funding sources of the Company; 4) they are an alternative interest-earning use of funds when loan demand is light; and 5) they can provide partially tax exempt income.  Aggregate investments were 29% of total assets at March 31, 2011, and 26% at December 31, 2010.

We had no fed funds outstanding at March 31, 2011, relative to $210,000 at December 31, 2010.  As noted above, however, our balance of interest-bearing balances at other banks was over $11 million at March 31, 2011, up from only $325,000 at the end of 2010, because excess balance sheet liquidity was placed in our Federal Reserve Bank account at higher yields than could be realized by selling fed funds.  Surplus liquidity, which was generated during the quarter from growth in deposits and loan runoff, was also deployed into longer-term, higher-yielding agency-issued mortgage-backed securities and municipal bonds, hence the book balance of the Company’s investment portfolio increased by $43 million, or 13%, during the first three months of 2011.  The book balance of our investment securities was $375 million at March 31, 2011.  Although the Company currently has the intent and the ability to hold the securities in its investment portfolio to maturity, the securities are all marketable and are classified as “available for sale” to allow maximum flexibility with regard to interest rate risk and liquidity management.  Pursuant to FASB’s guidance on accounting for debt and equity securities, available for sale securities are carried on the Company’s financial statements at their estimated fair market value, with monthly tax-effected “mark-to-market” adjustments made vis-à-vis accumulated other comprehensive income in shareholders’ equity.  The following table sets forth the Company’s investment portfolio by investment type as of the dates noted:

 
20

 

Investment Portfolio
           
(dollars in thousands, unaudited)
 
March 31,
   
December 31,
 
   
2011
   
2010
 
   
Amortized
   
Fair Market
   
Amortized
   
Fair Market
 
   
Cost
   
Value
   
Cost
   
Value
 
Available for Sale
                       
US Treasury securities
  $ -     $ -     $ -     $ -  
US Gov’t agencies
    4,914       4,970       4,954       5,062  
Mortgage-backed securities
    292,008       295,582       252,320       255,143  
State & political subdivisions
    72,012       72,917       70,201       70,102  
Other equity securities
    2,705       1,558       2,705       1,423  
Total Investment Securities
  $ 371,639     $ 375,027     $ 330,180     $ 331,730  

Mortgage-backed securities increased by $40 million, or 16%, net of prepayments, during the first three months of 2011.  The balance of municipal bonds increased by $3 million, or 4%, as the Company has also taken advantage of relative value in that sector.  It should be noted that all newly purchased municipal bonds have strong underlying ratings.  No equity securities were bought or sold during the first three months of 2011, although the market value of those securities increased slightly.  Investment portfolio securities that were pledged as collateral for FHLB borrowings, repurchase agreements, public deposits and for other purposes as required or permitted by law totaled $135 million at March 31, 2011 and $146 million at December 31, 2010, leaving $240 million in unpledged debt securities at March 31, 2011 and $186 million at December 31, 2010.  Securities pledged in excess of actual pledging needs, and thus available for liquidity purposes if necessary, totaled $84 million at March 31, 2011 and $103 million at December 31, 2010.

At March 31, 2011 and December 31, 2010, the Company had 121 securities and 141 securities, respectively, with unrealized losses.  Management has evaluated these securities as of the respective dates, and does not believe that any of the associated unrealized losses are other than temporary.  Information pertaining to these investment securities, aggregated by investment category and length of time that individual securities have been in a continuous loss position, is disclosed in the table below.

Investment Portfolio - Unrealized Losses
                       
(dollars in thousands, unaudited)
 
March 31, 2011
 
   
Less than 12 Months
   
Over 12 Months
 
   
Fair Value
   
Gross
 Unrealized
Losses
   
Fair Value
   
Gross
Unrealized
Losses
 
US Treasuries
  $ -     $ -     $ -     $ -  
US Government Agencies
    -       -       -       -  
Obligations of States and Political Subdivisions
    17,729       (430 )     2,521       (250 )
Agency-Issued Mortgage-Backed Securities (MBS)
    113,022       (819 )     -       -  
Private-Label MBS
    -       -       328       (1 )
Other Securities
    -       -       1,558       (1,148 )
TOTAL
  $ 130,751     $ (1,249 )   $ 4,407     $ (1,399 )
                                 
   
December 31, 2010
 
   
Less than 12 Months
   
Over 12 Months
 
   
Fair Value
   
Gross
Unrealized
Losses
   
Fair Value
   
Gross
Unrealized
Losses
 
US Treasuries
  $ -     $ -     $ -     $ -  
US Government Agencies
    -       -       -       -  
Obligations of States and Political Subdivisions
    24,728       (884 )     2,478       (283 )
Agency-Issued Mortgage-Backed Securities (MBS)
    108,203       (1,009 )     -       -