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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 JUNE 30, 2014

 

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 þ   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 þ      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 þ
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 þ

 

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, 13,970,266 shares outstanding as of July 31, 2014

 

 
 

  

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 Comprehensive Income 3
    Consolidated Statements of Cash Flows 4
    Notes to Unaudited Consolidated Financial Statements 5
       
  Item 2. Management’s Discussion & Analysis of Financial Condition & Results of Operations 27
    Forward-Looking Statements 27
    Critical Accounting Policies 27
    Overview of the Results of Operations and Financial Condition 28
    Earnings Performance 29
      Net Interest Income and Net Interest Margin 29
      Provision for Loan and Lease Losses 33
      Non-interest Income and Non-Interest Expense 34
      Provision for Income Taxes 36
    Balance Sheet Analysis 37
      Earning Assets 37
        Investments 37
        Loan and Lease Portfolio 38
        Nonperforming Assets 39
        Allowance for Loan and Lease Losses 40
        Off-Balance Sheet Arrangements 42
      Other Assets 42
      Deposits and Interest-Bearing Liabilities 43
        Deposits 43
        Other Interest-Bearing Liabilities 44
      Other Non-Interest Bearing Liabilities 44
    Liquidity and Market Risk Management 44
    Capital Resources 46
           
  Item 3. Qualitative & Quantitative Disclosures about Market Risk 48
           
  Item 4. Controls and Procedures 48
           
Part II - Other Information 49
  Item 1. - Legal Proceedings 49
  Item 1A. - Risk Factors 49
  Item 2. - Unregistered Sales of Equity Securities and Use of Proceeds 49
  Item 3. - Defaults upon Senior Securities 49
  Item 4. - (Removed and Reserved) 49
  Item 5. - Other Information 49
  Item 6. - Exhibits 50
     
Signatures 51

 

  

 
 

 

PART I - FINANCIAL INFORMATION

Item 1 – Financial Statements

 

SIERRA BANCORP

CONSOLIDATED BALANCE SHEETS

(dollars in thousands)

 

 

   June 30, 2014   December 31, 2013 
ASSETS   (unaudited)    (audited) 
Cash and due from banks  $44,796   $51,342 
Interest-bearing deposits in banks   4,028    26,664 
          Total cash & cash equivalents   48,824    78,006 
Investment securities available for sale   459,744    425,044 
Loans held for sale   -    105 
Loans and leases:          
     Gross loans and leases   893,041    803,242 
     Allowance for loan and lease losses   (11,634)   (11,677)
     Deferred loan and lease fees, net   1,393    1,522 
          Net loans and leases   882,800    793,087 
Premises and equipment, net   20,794    20,393 
Foreclosed assets   4,498    8,185 
Goodwill   5,544    5,544 
Other assets   75,835    79,885 
                                                           TOTAL ASSETS  $1,498,039   $1,410,249 
           
LIABILITIES AND SHAREHOLDERS' EQUITY          
LIABILITIES          
Deposits:          
     Non-interest bearing  $351,757   $365,997 
     Interest bearing   894,370    808,182 
          Total deposits   1,246,127    1,174,179 
Federal funds purchased and repurchase agreements   6,094    5,974 
Short-term borrowings   7,750    - 
Junior subordinated debentures   30,928    30,928 
Other liabilities   20,218    17,494 
                                                    TOTAL LIABILITIES   1,311,117    1,228,575 
SHAREHOLDERS' EQUITY          
     Common stock, no par value; 24,000,000 shares          
       authorized; 14,009,139 and 14,179,439 shares issued          
       and outstanding at June 30, 2014 and          
       December 31, 2013, respectively   65,310    65,780 
     Additional paid in capital   2,539    2,648 
     Retained earnings   115,580    112,817 
     Accumulated other comprehensive income   3,493    429 
                         TOTAL SHAREHOLDERS' EQUITY   186,922    181,674 
           
                                          TOTAL LIABILITIES AND          
                                        SHAREHOLDERS' EQUITY  $1,498,039   $1,410,249 

 

 

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)

 

 

 

   Three Months Ended June 30,   Six Months Ended June 30, 
Interest income:  2014   2013   2014   2013 
   Interest and fees on loans  $11,057   $11,368   $21,408   $22,275 
   Interest on investment securities:                    
     Taxable   1,876    1,034    3,701    2,196 
     Tax-exempt   733    672    1,474    1,291 
   Interest on federal funds sold and interest-bearing deposits   16    16    51    44 
          Total interest income   13,682    13,090    26,634    25,806 
                     
Interest expense:                    
   Interest on deposits   553    628    1,111    1,288 
   Interest on short-term borrowings   4    8    9    12 
   Interest on long-term borrowings   -    -    -    33 
   Interest on mandatorily redeemable trust preferred securities   175    179    349    356 
          Total interest expense   732    815    1,469    1,689 
                     
         Net Interest Income   12,950    12,275    25,165    24,117 
                     
Provision for loan losses   200    450    350    2,050 
                     
         Net Interest Income after Provision for Loan Losses   12,750    11,825    24,815    22,067 
                     
Non-interest income:                    
   Service charges on deposit accounts   2,039    2,215    3,925    4,288 
   Gains on investment securities available-for-sale   183    -    287    6 
   Other income, net   1,796    1,807    3,513    3,844 
          Total non-interest income   4,018    4,022    7,725    8,138 
                     
Non-interest expense:                    
   Salaries and employee benefits   5,328    5,403    11,313    11,323 
   Occupancy expense   1,532    1,596    3,037    3,147 
   Other   4,148    3,718    7,386    8,068 
         Total non-interest expense   11,008    10,717    21,736    22,538 
                     
          Income before income taxes   5,760    5,130    10,804    7,667 
                     
Provision for income taxes   1,523    1,331    2,768    1,535 
                     
Net Income  $4,237   $3,799   $8,036   $6,132 
                     
PER SHARE DATA                    
Book value  $13.34   $12.38   $13.34   $12.38 
Cash dividends  $0.08   $0.06   $0.16   $0.12 
Earnings per share basic  $0.30   $0.27   $0.57   $0.43 
Earnings per share diluted  $0.30   $0.27   $0.56   $0.43 
Average shares outstanding, basic   14,086,939    14,128,146    14,157,103    14,120,865 
Average shares outstanding, diluted   14,212,532    14,227,335    14,291,359    14,211,910 
                     
Total shareholder equity (in thousands)  $186,922   $175,171   $186,922   $175,171 
Shares outstanding   14,009,139    14,144,439    14,009,139    14,144,439 
Dividends Paid  $1,137,910   $847,358   $2,267,656   $1,694,024 

 

 

 

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

 

2
 

  

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(dollars in thousands, unaudited)

 

 

   Three months ended June 30,   Six months ended June 30, 
   2014   2013   2014   2013 
                 
Net Income  $4,237   $3,799   $8,036   $6,132 
Other comprehensive income, before tax:                    
   Unrealized gains on securities:                    
         Unrealized holding gains (losses) arising during period   3,927    (6,157)   5,493    (6,242)
         Less: reclassification adjustment for gains (1)
         included in net income
   (183)   -    (287)   (6)
Other comprehensive income (loss), before tax   3,744    (6,157)   5,206    (6,248)
   Income tax expense related to items of other                    
         comprehensive (loss) income, net of tax   (1,540)   2,534    (2,142)   2,571 
Other comprehensive income (loss)   2,204    (3,623)   3,064    (3,677)
                     
Comprehensive Income  $6,441   $176   $11,100   $2,455 

 

 

(1) Amounts are included in net gains on investment securities available-for-sale on the Consolidated Statements of Income in non-interest revenue. Income tax expense associated with the reclassification adjustment for the three months ended June 30, 2014 and 2013 was $75 thousand and zero respectively. Income tax expense associated with the reclassification adjustment for the six months ended June 30, 2014 and 2013 was $118 thousand and $2 thousand respectively.

 

 

 

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

 

3
 

 

 

SIERRA BANCORP

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands, unaudited)

 

   Six Months Ended June 30, 
   2014   2013 
Cash flows from operating activities:          
     Net income  $8,036   $6,132 
     Adjustments to reconcile net income to net cash          
        provided by operating activities:          
    Gain on sales of securities   (287)   (6)
    Gain on sales of loans   (3)   (68)
    Gain on disposal of fixed assets   -    (15)
    (Gain) loss on sale on foreclosed assets   (469)   269 
    Writedowns on foreclosed assets   223    188 
    Share-based compensation expense   33    150 
    Provision for loan losses   350    2,050 
    Depreciation   1,038    1,151 
    Net amortization on securities premiums and discounts   3,285    4,337 
    Increase in unearned net loan fees   (129)   (81)
    Increase in cash surrender value of life insurance policies   (806)   (933)
    Proceeds from sales of loans portfolio   108    2,288 
    Increase in loans held-for-sale   -    (2,533)
    Decrease in interest receivable and other assets   2,071    3,641 
    Decrease (increase) in other liabilites   2,724    (633)
    Net (Increase) decrease in FHLB stock   (190)   438 
    Deferred income tax provision   833    8 
    Excess tax benefit from equity based compensation   -    (103)
          Net cash provided by operating activities   16,817    16,280 
           
Cash flows from investing activities:          
    Maturities of securities available for sale   450    439 
    Proceeds from sales/calls of securities available for sale   9,210    1,221 
    Purchases of securities available for sale   (78,426)   (77,966)
    Principal pay downs on securities available for sale   36,274    52,339 
    Net (increase) decrease in loans receivable, net   (90,117)   63,776 
    Purchases of premises and equipment, net   (1,439)   (226)
    Proceeds from sales of foreclosed assets   4,116    10,546 
          Net cash (used in) provided by investing activities   (119,932)   50,129 
           
Cash flows from financing activities:          
    Increase (decrease) in deposits   71,948    (19,019)
    Increase (decrease) in borrowed funds   7,750    (41,650)
    Increase in Fed funds purchased   -    544 
    Increase in repurchase agreements   120    - 
    Cash dividends paid   (2,268)   (1,694)
    Repurchases of common stock   (4,281)   - 
    Stock options exercised   664    471 
    Excess tax benefit from equity based compensation   -    103 
          Net cash provided by (used in) financing activities   73,933    (61,245)
           
       (Decrease) increase in cash and due from banks   (29,182)   5,164 
           
Cash and cash equivalents          
     Beginning of period   78,006    61,818 
     End of period  $48,824   $66,982 

 

 

 

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

 

4
 

 

Sierra Bancorp

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2014

 

 

 

 

Note 1 – The Business of Sierra Bancorp

 

Sierra Bancorp (the “Company”) is a California corporation headquartered in Porterville, California, and is a registered bank holding company under federal banking laws. The Company was formed to serve as the holding company for Bank of the Sierra (the “Bank”), and has been the Bank’s sole shareholder since August 2001. 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 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 (TRUPS). 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 Company’s financial statements. 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 primarily to communities in the central and southern regions 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 online. In addition to our full-service branches the Bank has a real estate industries group, an agricultural credit division, an SBA lending unit, and offsite ATMs at six 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 US 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 2013 have been reclassified to be consistent with the reporting for 2014. 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, 2013, as filed with the Securities and Exchange Commission.

 

Note 3 – Current Accounting Developments

 

In January 2014, the FASB issued Accounting Standards Update (ASU) 2014-01, Investments—Equity Method and Joint Ventures (Topic 323): Accounting for Investments in Qualified Affordable Housing Projects, to provide additional flexibility with regard to accounting for investments in qualified affordable housing projects. ASU 2014-01 modifies the conditions that must be met to present the pretax impact and related tax benefits of such investments as a component of income taxes (“net” within income tax expense), to enable more investors to elect to use a “net” presentation for those investments. Investors that do not qualify for “net” presentation under the new guidance will continue to account for such investments under the equity method or cost method, which results in losses recognized in pretax income and tax benefits recognized in income taxes (“gross” presentation of investment results). For investments that qualify for the “net” presentation of investment performance, ASU 2014-01 introduces a “proportional amortization method” that can be elected to amortize the investment basis. If elected, the method is required for all eligible investments in qualified affordable housing projects. ASU 2014-01 also requires enhanced recurring disclosures for all investments in qualified affordable housing projects, regardless of the accounting method used for those investments. It is effective for interim and annual periods beginning after December 15, 2014, and early adoption is permitted. The Company currently expects to adopt ASU 2014-01 as of the first quarter of 2015. We will likely continue to account for our low-income housing tax credit investments using the equity method subsequent to our adoption of ASU 2014-01 and thus do not expect any impact on our income statement or balance sheet, but our disclosures with regard to low-income housing tax credit investments will be updated to reflect the new requirements.

 

5
 

 

In January 2014, the FASB issued ASU 2014-04, Receivables—Troubled Debt Restructurings by Creditors (Subtopic 310-40): Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure, to resolve diversity in practice with respect to a creditor’s reclassification of a collateralized consumer mortgage loan to other real estate owned (OREO). Current US GAAP requires a loan to be reclassified to OREO upon a troubled debt restructuring that is “in substance a repossession or foreclosure”, where the creditor receives “physical possession” of the debtor's assets regardless of whether formal foreclosure proceedings take place. The terms “in substance a repossession or foreclosure” and “physical possession” are not defined in US GAAP; therefore, questions have arisen about when a creditor should reclassify a collateralized mortgage loan to OREO. ASU 2014-04 requires a creditor to reclassify a collateralized consumer mortgage loan to real estate property upon obtaining legal title to the real estate collateral, or when the borrower voluntarily conveys all interest in the real estate property to the lender to satisfy the loan through a deed in lieu of foreclosure or similar legal agreement. ASU 2014-04 is effective for public business entities for interim and annual periods beginning after December 15, 2014. It will be adopted by the Company for the first quarter of 2015, and we do not expect any impact upon our financial statements or operations upon adoption.

 

Note 4 – Supplemental Disclosure of Cash Flow Information

 

During the six months ended June 30, 2014 and 2013, cash paid for interest due on interest-bearing liabilities was $1.502 million and $1.794 million, respectively. There was $160,000 in cash paid for income taxes during the six months ended June 30, 2014, but no cash paid for income taxes for the six months ended June 30, 2013. Assets totaling $184,000 and $2.622 million were acquired in settlement of loans for the six months ended June 30, 2014 and June 30, 2013, respectively. We received $4.116 million in cash from the sale of foreclosed assets during the first six months of 2014 relative to $10.156 million during the first six months of 2013, which represents sales proceeds less loans extended to finance such sales.

 

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 123,950 shares that were granted under the 1998 Plan were still outstanding as of June 30, 2014 and remain unaffected by that plan’s 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 for issuance pursuant to awards under the 2007 Plan was initially 1,500,000 shares, although the number remaining available for grant as of June 30, 2014 was 829,920. The dilutive impact of stock options outstanding is discussed below in Note 6, Earnings per Share. No restricted stock awards have been issued by the Company.

 

Pursuant to FASB’s standards on stock compensation, the value of each option granted is reflected in our income statement as employee compensation or directors’ expense by amortizing the value over the vesting period of such option or by expensing it as of the grant date for immediately vested options. 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, which appears to be the preferred method for option grants with graded vesting. A pre-tax charge of $21,000 was reflected in the Company’s income statement during the second quarter of 2014 and $57,000 was charged during the second quarter of 2013, as expense related to stock options. For the first half, the charges totaled $33,000 in 2014 and $151,000 in 2013.

 

Note 6 – Earnings per Share

 

The computation of earnings per share, as presented in the Consolidated Statements of Income, is based on the weighted average number of shares outstanding during each period. There were 14,086,939 weighted average shares outstanding during the second quarter of 2014, and 14,128,146 during the second quarter of 2013. There were 14,157,103 weighted average shares outstanding during the first six months of 2014, and 14,120,865 during the first six months of 2013.

 

6
 

 

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 “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 second quarter and first six months of 2014 the dilutive effect of options outstanding calculated under the treasury stock method totaled 125,593 and 134,256, respectively, which were added to basic weighted average shares outstanding for purposes of calculating diluted earnings per share. Likewise, for the second quarter and first six months of 2013 shares totaling 99,189 and 91,045, respectively, were added to basic weighted average shares outstanding in order to calculate diluted earnings per share.

 

Note 7 – Comprehensive Income

 

As presented in the Consolidated Statements of Comprehensive Income, comprehensive income includes net income and other comprehensive income. The Company’s only source of other comprehensive income is unrealized gains and losses on available-for-sale investment securities. Gains or losses on investment securities that were realized and included in net income of the current period, which had previously been included in other comprehensive income as unrealized holding gains or losses in the period in which they arose, are considered to be reclassification adjustments that are excluded from other comprehensive income in the current period.

 

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. Those financial instruments consist of unused 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 counterparties 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 originating loans included on the balance sheet. The following financial instruments represent off-balance-sheet credit risk (dollars in thousands):

 

   June 30, 2014   December 31, 2013 
Commitments to extend credit  $386,378   $420,707 
Standby letters of credit  $8,884   $8,703 
Commercial letters of credit  $8,069   $8,070 

 

Commitments to extend credit consist primarily of the unused or unfunded portions of the following: home equity lines of credit; commercial real estate construction loans, where disbursements are made over the course of construction; commercial revolving lines of credit; mortgage warehouse lines of credit; unsecured personal lines of credit; and formalized (disclosed) deposit account overdraft lines. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many commitments are expected to expire without being drawn upon, the unused portions of committed 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 the risk involved in extending loans to customers.

 

The Company is also utilizing an $88 million letter of credit issued by the Federal Home Loan Bank on the Company’s behalf as security for certain deposits. The letter of credit is backed by loans which are pledged to the Federal Home Loan Bank by the Company.

 

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

 

FASB’s standards on financial instruments, and on fair value measurements and disclosures, require all entities to disclose in their financial statement footnotes the estimated fair values of financial instruments for which it is practicable to estimate fair values. In addition to 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. FASB’s standard on financial instruments permits companies to report certain other financial assets and liabilities at fair value, but we have not elected the fair value option for any additional financial assets or liabilities.

 

7
 

 

Fair value measurements and disclosure standards also establish a framework for measuring fair values. 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, the standards establish a fair value hierarchy that encourages an entity to maximize the use of observable inputs and limit the use of unobservable inputs when measuring fair values. The standards describe three levels of inputs that may be used to measure fair values:

 

·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 likely 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. The 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 realized gains and losses could have a significant effect on fair value estimates but 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. The estimates are subjective 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 June 30, 2014 and December 31, 2013:

 

·Cash and cash equivalents and fed funds sold: The carrying amount is estimated to be fair value.

 

·Investment securities: Fair values 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 their relationship to other benchmark quoted securities when quoted prices for specific securities 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. The carrying amount of accrued interest receivable approximates its fair value.

 

·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 not relevant for reporting purposes. If available-for-sale loans are on our books for an extended period of time, the fair value of those loans is determined using quoted secondary-market prices.

 

·Collateral-dependent impaired loans: Collateral-dependent impaired loans are carried at fair value when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the original loan agreement and the loan has been written down to the fair value of its underlying collateral, net of expected disposition costs where applicable.

 

·Cash surrender value of life insurance policies: Fair values are based on net cash surrender values at each reporting date.

 

8
 

 

·Investments 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: Certain investments for which no secondary market exists are carried at cost unless an impairment analysis indicates the need for adjustments, and the carrying amount for those investments approximates their estimated fair value.

 

·Deposits: Fair values for non-maturity deposits are equal to the amount payable on demand at the reporting date, which is the 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 approximate fair values for federal funds purchased, overnight FHLB advances, borrowings under repurchase agreements, and other short-term borrowings maturing within ninety days of the reporting dates. 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: Fair values are estimated using projected cash flows discounted at the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

 

·Subordinated debentures: Fair values are determined based on the current market value for like instruments of a similar maturity and structure.

 

·Commitments to extend credit and letters of credit: If funded, the carrying amounts for currently unused commitments 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 those 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 are as follows, as of the dates noted:

 

9
 

 

Fair Value of Financial Instruments                
(dollars in thousands, unaudited)  June 30, 2014 
       Estimated Fair Value 
   Carrying
Amount
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant
Observable Inputs
(Level 2)
   Significant
Unobservable Inputs
(Level 3)
   Total 
Financial assets:                         
Cash and cash equivalents  $48,824   $48,824   $-   $-   $48,824 
Investment securities available for sale   459,744    2,487    457,257    -    459,744 
Loans and leases, net held for investment   862,856    -    874,610    -    874,610 
Collateral dependent impaired loans   19,944    -    19,944    -    19,944 
Loans held-for-sale   -    -    -    -    - 
Cash surrender value of life insurance policies   40,230    -    40,230    -    40,230 
Other investments   6,122    -    6,122    -    6,122 
Investment in limited partnership   7,883    -    7,883    -    7,883 
Accrued interest receivable   5,196    -    5,196    -    5,196 
                          
Financial liabilities:                         
Deposits:                         
   Noninterest-bearing  $351,757   $351,757   $-   $-   $351,757 
   Interest-bearing   894,370    -    894,611    -    894,611 
Fed funds purchased and
   repurchase agreements
   6,094    -    6,094    -    6,094 
Short-term borrowings   7,750    -    7,750    -    7,750 
Long-term borrowings   -    -    -    -    - 
Subordinated debentures   30,928    -    11,267    -    11,267 
Limited partnership capital commitment   914    -    914    -    914 
Accrued interest payable   153    -    153    -    153 
                          
    Notional Amount                     
Off-balance-sheet financial instruments:                         
Commitments to extend credit  $386,378                     
Standby letters of credit   8,884                     
Commercial lines of credit   8,069                     
                          

 

   December 31, 2013 
       Estimated Fair Value 
   Carrying
Amount
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)
   Total 
Financial assets:                         
Cash and cash equivalents  $78,006   $78,006   $-   $-   $78,006 
Investment securities available for sale   425,044    2,456    422,588    -    425,044 
Loans and leases, net held for investment   778,382    -    797,383    -    797,383 
Collateral dependent impaired loans   14,705    -    14,705    -    14,705 
Loans held-for-sale   105    105    -    -    105 
Cash surrender value of life insurance policies   39,424    -    39,424    -    39,424 
Other Investments   5,932    -    5,932    -    5,932 
Investment in limited partnership   9,204    -    9,204    -    9,204 
Accrued interest receivable   4,990    -    4,990    -    4,990 
                          
Financial liabilities:                         
Deposits:                         
   Noninterest-bearing  $365,997   $365,997   $-   $-   $365,997 
   Interest-bearing   808,182    -    808,182    -    808,182 
Fed funds purchased and
   repurchase agreements
   5,974    -    5,974    -    5,974 
Short-term borrowings   -    -    -    -    - 
Long-term borrowings   -    -    -    -    - 
Subordinated debentures   30,928    -    11,175    -    11,175 
Limited partnership capital commitment   962    -    962    -    962 
Accrued interest payable   186    -    186    -    186 
                          
    Notional Amount                     
Off-balance-sheet financial instruments:                         
Commitments to extend credit  $420,707                     
Standby letters of credit   8,703                     
Commercial lines of credit   8,070                     

 

10
 

 

 

For financial asset categories that were actually reported at fair value at June 30, 2014 and December 31, 2013, the Company used the following methods and significant assumptions:

 

·Investment securities: Fair values 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 their relationship to other benchmark quoted securities.

 

·Collateral-dependent impaired loans: Collateral-dependent impaired loans are carried at fair value when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the original loan agreement and the loan has been written down to the fair value of its underlying collateral, net of expected disposition costs where applicable.

 

·Foreclosed assets: Repossessed real estate (OREO) and other foreclosed assets are carried at the lower of cost or fair value. Fair value is the appraised value less expected selling costs for OREO and some other assets such as mobile homes, and for any other foreclosed assets fair value is represented by the estimated sales proceeds as determined using reasonably available sources. Foreclosed assets for which appraisals can be feasibly obtained are periodically measured for impairment using updated appraisals. Fair values for other foreclosed assets are adjusted as necessary, subsequent to a periodic re-evaluation of expected cash flows and the timing of resolution. 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: 

 

Fair Value Measurements - Recurring                
(dollars in thousands, unaudited)                
   Fair Value Measurements at June 30, 2014, using 
                 
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant
Observable Inputs
(Level 2)
   Significant
Unobservable Inputs
(Level 3)
   Total 
Investment securities                    
US Government agencies  $-   $4,672   $-   $4,672 
Mortgage-backed securities   -    354,186    -    354,186 
 State and poltical subdivisions   -    98,399    -    98,399 
Equity securities   2,487    -    -    2,487 
                     
Total available-for-sale securities  $2,487   $457,257   $-   $459,744 
                     
                     
                     

 

11
 

 

   Fair Value Measurements at December 31, 2013, using 
                 
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant
Observable Inputs
(Level 2)
   Significant
Unobservable Inputs
(Level 3)
   Total 
Investment securities                
US Government agencies  $-   $5,304   $-   $5,304 
Mortgage-backed securities   -    320,721    -    320,721 
 State and poltical subdivisions   -    96,563    -    96,563 
Equity securities   2,456    -    -    2,456 
                     
Total available-for-sale securities  $2,456   $422,588   $-   $425,044 

 

Assets reported at fair value on a nonrecurring basis are summarized below: 

 

Fair Value Measurements - Nonrecurring              
(dollars in thousands, unaudited)                
   Fair Value Measurements at June 30, 2014, Using 
                 
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant Observable Inputs
(Level 2)
   Significant
Unobservable Inputs
(Level 3)
   Total 
Collateral dependent impaired loans  $-   $19,944   $-   $19,944 
Foreclosed assets  $-   $4,498   $-   $4,498 
                     

 

   Fair Value Measurements at December 31, 2013, using 
                 
   Quoted Prices in
Active Markets for
Identical Assets
(Level 1)
   Significant Observable Inputs
(Level 2)
   Significant
Unobservable Inputs
(Level 3)
   Total 
Collateral dependent impaired loans  $-   $14,705   $-   $14,705 
Foreclosed assets  $-   $8,185   $-   $8,185 

 

The table above includes collateral-dependent 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 Note 11 below, and in Management’s Discussion and Analysis of Financial Condition and Results of Operation in the “Nonperforming Assets” and “Allowance for Loan and Lease Losses” sections. 

 

12
 

 

The unobservable inputs are based on management’s best estimates of appropriate discounts in arriving at fair market value. Increases or decreases in any of those inputs could result in a significantly lower or higher fair value measurement. For example, a change in either direction of actual loss rates would have a directionally opposite change in the calculation of the fair value of unsecured impaired loans.

 

Note 10 – Investments

 

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 values, with monthly tax-effected “mark-to-market” adjustments made vis-à-vis accumulated other comprehensive income in shareholders’ equity.

 

The table below summarizes the Company’s available-for-sale investment securities by type, as of the dates indicated:

 

Amortized Cost And Estimated Fair Value
(dollars in thousands, unaudited)                        
    June 30, 2014  
    Amortized Cost     Gross
Unrealized Gains
    Gross
Unrealized Losses
    Estimated Fair Value  
                         
US Government agencies   $ 4,743     $ 7     $ (78 )   $ 4,672  
Mortgage-backed securities     351,139       4,411       (1,364 )     354,186  
 State and poltical subdivisions     96,592       2,623       (816 )     98,399  
Equity securities     1,336       1,151       -       2,487  
     Total investment securities   $ 453,810     $ 8,192     $ (2,258 )   $ 459,744  
                                 

  

   December 31, 2013 
   Amortized Cost   Gross
Unrealized Gains
   Gross
Unrealized Losses
   Estimated Fair Value 
                 
US Government agencies  $5,395   $18   $(109)  $5,304 
Mortgage-backed securities   320,223    3,269    (2,771)   320,721 
State and political subdivisons   97,361    1,723    (2,521)   96,563 
Equity securities   1,336    1,120    -    2,456 
     Total investment securities  $424,315   $6,130   $(5,401)  $425,044 

 

13
 

 

At June 30, 2014 and December 31, 2013, the Company had 158 securities and 197 securities, respectively, with unrealized losses. Management has evaluated those securities as of the respective dates, and does not believe that any of the associated unrealized losses are other than temporary. Information pertaining to our investment securities with unrealized losses, 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)  June 30, 2014 
   Less than Twelve Months   Over Twelve Months 
   Gross
Unrealized Losses
   Fair Value   Gross
Unrealized Losses
   Fair Value 
                 
US Government agencies  $(20)  $1,707   $(58)  $2,332 
Mortgage-backed securities   (338)   60,577    (1,026)   72,589 
State and political subdivisions   (44)   5,929    (772)   26,249 
Other securities   -    -    -    - 
    Total investment securities  $(402)  $68,213   $(1,856)  $101,170 
                     
                     

 

   December 31, 2013 
   Less than Twelve Months   Over Twelve Months 
   Gross
Unrealized Losses
   Fair Value   Gross
Unrealized Losses
   Fair Value 
                 
                 
US Government agencies  $(92)  $1,913   $(17)  $1,920 
Mortgage-backed securities   (642)   21,747    (2,129)   124,317 
State and political subdivisions   (461)   6,799    (2,060)   38,083 
Other securities   -    -    -    - 
    Total investment securities  $(1,195)  $30,459   $(4,206)  $164,320 

 

 

14
 

 

The table below summarizes the Company’s gross realized gains and losses as well as gross proceeds from the sales of securities: 

 

Investment Portfolio - Realized Gains/(Losses)                
(dollars in thousands, unaudited)                
                 
   Three months ended June 30,   Six months ended June 30, 
   2014   2013   2014   2013 
                 
Proceeds from sales of securities available for sale  $4,995   $-   $8,360   $264 
                     
Gross gains on sale of securities available for sale  $185   $-   $289   $6 
Gross losses on sale of securities available for sale   (2)   -    (2)   - 
Net gains on sale of securities available for sale  $183   $-   $287   $6 

 

The amortized cost and estimated fair value of investment securities available-for-sale at June 30, 2014 and December 31, 2014 by contractual maturity are shown below. Expected maturities will differ from contraction maturities because the issuers of the securities may have the right to call or prepay obligations with or without penalties. 

 

Estimated Fair Value of Contractual Maturities        
(dollars in thousands, unaudited)  June 30, 2014 
   Amortized Cost   Fair Value 
         
         
Maturing within one year  $3,062   $3,077 
Maturing after one year through five years   222,327    225,395 
Maturing after five years through ten years   64,030    65,120 
Maturing after ten years   51,477    51,642 
           
           
Investment securities not due at a single maturity date:          
          U.S Government agencies collateralized by          
          mortgage obligations   111,578    112,024 
          Other securities   1,336    2,486 
   $453,810   $459,744 
           

 

   December 31, 2013 
   Amortized Cost   Fair Value 
         
         
Maturing within one year  $2,294   $2,316 
Maturing after one year through five years   241,396    242,493 
Maturing after five years through ten years   59,572    59,402 
Maturing after ten years   49,674    47,737 
           
           
Investment securities not due at a single maturity date:          
          U.S Government agencies collateralized by          
          mortgage obligations   70,043    70,640 
          Other securities   1,336    2,456 
   $424,315   $425,044 

 

15
 

 

At June 30, 2014, the Company’s investment portfolio included securities issued by 246 different government municipalities and agencies located within 27 states with a fair value of $98.4 million. The largest exposure to any single municipality or agency was a $4.5 million (fair value) bond issued for water utility improvements by the Arizona State Water Infrastructure Finance Authority, to be repaid by future water revenue.

 

The Company’s investments in bonds issued by states, municipalities and political subdivisions are evaluated in accordance with Supervision and Regulation Letter 12-15 (SR 12-15) issued by the Board of Governors of the Federal Reserve System, “Investing in Securities without Reliance on Nationally Recognized Statistical Rating Organization Ratings”, and other regulatory guidance. Credit ratings are considered in our analysis only as a guide to the historical default rate associated with similarly-rated bonds. There have been no significant differences in our internal analyses compared with the ratings assigned by the third party credit rating agencies.

 

The following table summarizes the total general obligation and revenue bonds in the Company’s investment securities portfolio at June 30, 2014, including the state in which the issuing government municipality or agency operates when such state represents an investment concentration: 

 

Revenue and General Obligation Bonds by Location            
dollars in thousands, unaudited  June 30, 2014   December 31, 2013 
             
   Amortized   Fair Market   Amortized   Fair Market 
General obligation bonds  Cost   Value   Cost   Value 
State of issuance                    
California  $22,103   $23,139   $20,638   $21,272 
Texas   12,450    12,496    11,340    11,024 
Illinois   8,301    8,333    8,965    8,702 
Ohio   7,646    7,669    7,659    7,485 
Washington   5,997    6,087    5,487    5,340 
Arizona   2,085    2,145    2,100    2,050 
Other states   19,663    20,014    20,666    20,429 
Total General Obligation Bonds   78,245    79,883    76,855    76,302 
                     
Revenue bonds                    
State of issuance                    
Arizona   4,645    4,482    4,700    4,341 
Texas   3,294    3,362    2,762    2,719 
California   2,169    2,235    2,519    2,579 
Washington   1,169    1,206    1,170    1,211 
Ohio   323    337    324    339 
Other states   6,747    6,894    6,758    6,742 
Total Revenue Bonds   18,347    18,516    18,233    17,931 
                     
Certificates of participation (All California)   -    -    2,273    2,330 
                     
Total Obligations of States                    
     and Political Subdivisions  $96,592   $98,399   $97,361   $96,563 

 

16
 

  

At June 30, 2014, the revenue bonds in the Company’s investment securities portfolios were issued by government municipalities and agencies to fund public services such as utilities (water, sewer, and power), educational facilities, and general public and economic improvements. The revenue bonds were payable from 12 different types of revenue sources. The revenue sources that represent 5% or more individually as a percent of the total revenue bonds are summarized in the following table: 

 

Revenue Bonds by Type        
dollars in thousands, unaudited  June 30, 2014   December 31, 2013 
         
   Amortized   Fair Market   Amortized   Fair Market 
Revenue bonds  Cost   Value   Cost   Value 
Revenue source:                    
Water  $7,350   $7,295   $7,409   $7,144 
College & University   2,739    2,812    2,203    2,187 
Electric & Power   1,884    1,919    1,888    1,895 
Sales Tax   1,673    1,713    1,673    1,688 
Lease   1,356    1,337    1,155    1,063 
Other sources   3,345    3,440    3,905    3,954 
Total Revenue Bonds  $18,347   $18,516   $18,233   $17,931 

 

Note 11 – Credit Quality and Nonperforming Assets

 

Credit Quality Classifications

 

The Company monitors the credit quality of loans on a continuous basis using the regulatory and accounting classifications of pass, special mention, substandard and impaired to characterize the associated credit risk. Balances classified as “loss” are immediately charged off. The Company conforms to the following definitions for risk classifications utilized:

 

·Pass: Larger non-homogeneous loans not meeting the risk rating definitions below, and smaller homogeneous loans that are not assessed on an individual basis.

 

·Special mention: Loans which have potential issues that deserve the close attention of management. If left uncorrected, those potential weaknesses could eventually diminish the prospects for full repayment of principal and interest according to the contractual terms of the loan agreement, or could result in deterioration of the Company’s credit position at some future date.

 

·Substandard: Loans that have at least one clear and well-defined weakness which could jeopardize the ultimate recoverability of all principal and interest, such as a borrower displaying a highly leveraged position, unfavorable financial operating results and/or trends, uncertain repayment sources or a deteriorated financial condition.

 

·Impaired: A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans include all nonperforming loans, restructured troubled debt (TDRs), and certain other loans that are still being maintained on accrual status. A TDR may be nonperforming or performing, depending on its accrual status and the demonstrated ability of the borrower to comply with restructured terms (see “Troubled Debt Restructurings” section below for additional information on TDRs).

  

17
 

 

Credit quality classifications for the Company’s loan balances were as follows, as of the dates indicated:

  

Credit Quality Classifications                    
(dollars in thousands, unaudited)                    
   June 30, 2014 
   Pass   Special Mention   Substandard   Impaired   Total 
             
Real Estate:                         
1-4 family residential construction  $4,120   $-   $-   $-   $4,120 
Other construction/land   17,967    299    10    4,878    23,154 
1-4 family - closed end   97,789    927    609    14,535    113,860 
Equity lines   47,591    213    1,250    2,268    51,322 
Multi-family residential   6,565    423    -    -    6,988 
Commercial real estate - owner occupied   177,779    21,534    3,635    4,708    207,656 
Commercial real estate - non-owner occupied   89,255    3,575    228    12,945    106,003 
Farmland   122,982    2,459    79    173    125,693 
             Total real estate   564,048    29,430    5,811    39,507    638,796 
                          
Agricultural   24,812    646    357    327    26,142 
Commercial and Iindustrial   95,907    1,900    289    3,252    101,348 
Mortgage Warehouse   106,157    -    -    -    106,157 
Consumer loans   17,018    416    113    3,051    20,598 
Total gross loans and leases  $807,942   $32,392   $6,570   $46,137   $893,041 
                          

 

   December 31, 2013 
   Pass   Special Mention   Substandard   Impaired   Total 
             
Real Estate:                         
1-4 family residential construction  $1,720   $-   $-   $-   $1,720 
Other construction/land   18,243    334    203    6,751    25,531 
1-4 family - closed end   67,051    1,305    770    17,898    87,024 
Equity lines   51,019    254    1,429    1,021    53,723 
Multi-family residential   8,059    426    -    -    8,485 
Commercial real estate - owner occupied   158,155    17,033    3,261    7,563    186,012 
Commercial real estate - non-owner occupied   89,475    3,630    240    13,495    106,840 
Farmland   105,623    1,780    819    282    108,504 
             Total real estate   499,345    24,762    6,722    47,010    577,839 
                          
Agricultural   24,178    532    -    470    25,180 
Commercial and industrial   93,224    3,358    1,236    5,444    103,262 
Mortgage Warehouse   73,425    -    -    -    73,425 
Consumer loans   19,387    478    208    3,463    23,536 
Total gross loans and leases  $709,559   $29,130   $8,166   $56,387   $803,242 

 

Past Due and Nonperforming Assets

 

Nonperforming assets are comprised of loans for which the Company is no longer accruing interest, and foreclosed assets, including mobile homes and other real estate owned (OREO). OREO consists of properties acquired by foreclosure or similar means, which the Company is offering or will offer for sale. Nonperforming loans and leases result when reasonable doubt surfaces with regard to the ability of the Company to collect all principal and interest. At that point, we stop accruing interest on the loan or lease in question and reverse any previously-recognized interest to the extent that it is uncollected or associated with interest-reserve loans. Any asset for which principal or interest has been in default for 90 days or more is also placed on non-accrual status even if interest is still being received, unless the asset is both well secured and in the process of collection. An aging of the Company’s loan balances is presented in the following tables, by number of days past due as of the indicated dates:

 

18
 

  

Loan Portfolio Aging                            
(dollars in thousands, unaudited)                            
   June 30, 2014 
   30-59 Days
Past Due
   60-89 Days
Past Due
   90 Days
Or More
Past Due(2)
   Total Past Due   Current   Total Financing Receivables   Non-Accrual Loans(1) 
                 
Real Estate:                                   
1-4 family residential construction  $-   $7   $-   $7   $4,113   $4,120   $- 
Other construction/land   -    3,682    -    3,682    19,472    23,154    3,682 
1-4 family - closed end   125    2,707    -    2,832    111,028    113,860    10,071 
Equity lines   6    86    838    930    50,392    51,322    1,997 
Multi-family residential   -    -    -    -    6,988    6,988    - 
Commercial real estate - owner occupied   218    362    1,640    2,220    205,436    207,656    3,485 
Commercial real estate - non-owner occupied   834    202    6,842    7,878    98,125    106,003    7,671 
Farmland   937    -    -    937    124,756    125,693    173 
             Total real estate   2,120    7,046    9,320    18,486    620,310    638,796    27,079 
                                    
Agricultural   159    358    327    844    25,298    26,142    327 
Commercial and industrial   399    -    401    800    100,548    101,348    992 
Mortgage Warehouse   -    -    -    -    106,157    106,157    - 
Consumer loans   212    -    39    251    20,347    20,598    838 
Total gross loans and leases  $2,890   $7,404   $10,087   $20,381   $872,660   $893,041   $29,236 

  

(1) Included in total financing receivables                      

(2) As of  June 30, 2014 there were no loans over 90 days past due and still acrruing.

                           

 

   December 31, 2013 
   30-59 Days
Past Due
   60-89 Days
Past Due
   90 Days
Or More
Past Due(2)
   Total Past Due   Current   Total Financing Receivables   Non-Accrual Loans(1) 
                 
Real Estate:                                   
1-4 family residential construction  $-   $-   $-   $-   $1,720   $1,720   $- 
Other construction/land   294    -    116    410    25,121    25,531    5,528 
1-4 family - closed end   2,181    300    171    2,652    84,372    87,024    13,168 
Equity lines   98    -    288    386    53,337    53,723    778 
Multi-family residential   -    -    -    -    8,485    8,485    - 
Commercial real estate - owner occupied   1,917    144    2,011    4,072    181,940    186,012    5,516 
Commercial real estate - non-owner occupied   -    -    7,667    7,667    99,173    106,840    8,058 
     Farmland   331    -    -    331    108,173    108,504    282 
             Total real estate   4,821    444    10,253    15,518    562,321    577,839    33,330 
                                    
Agricultural   892    327    125    1,344    23,836    25,180    470 
Commercial and industrial   1,318    587    1,298    3,203    100,059    103,262    2,622 
Mortgage Warehouse   -    -    -    -    73,425    73,425    - 
Consumer loans   181    -    -    181    23,355    23,536    992 
Total gross loans and leases  $7,212   $1,358   $11,676   $20,246   $782,996   $803,242   $37,414 

 

(1) Included in total financing receivables

(2) As of December 31, 2013 there were no loans over 90 days past due and still accruing.                                

 

19
 

  

Troubled Debt Restructurings

 

A loan that is modified for a borrower who is experiencing financial difficulty is classified as a troubled debt restructuring (TDR), if the modification constitutes a concession. At June 30, 2014, the Company had a total of $34.6 million in TDRs, including $21.4 million in TDRs that were on non-accrual status. Generally, a non-accrual loan that has been modified as a TDR remains on non-accrual status for a period of at least six months to demonstrate the borrower’s ability to comply with the modified terms. However, performance prior to the modification, or significant events that coincide with the modification, could result in a loan’s return to accrual status after a shorter performance period or even at the time of loan modification. TDRs may have the TDR designation removed in the calendar year following the restructuring, if the loan is in compliance with all modified terms and is yielding a market rate of interest. Regardless of the period of time that has elapsed, if the borrower’s ability to meet the revised payment schedule is uncertain then the loan will be kept on non-accrual status. Moreover, a TDR is generally considered to be in default when it appears that the customer will not likely be able to repay all principal and interest pursuant to the terms of the restructured agreement.

 

The Company may agree to different types of concessions when modifying a loan or lease. The tables below summarize TDRs which were modified during the noted periods, by type of concession: 

 

Troubled Debt Restructurings, by Type of Loan Modification                    
(dollars in thousands, unaudited)                                
   For the six months Ended Ended June 30, 2014 
     
   Rate Modification   Term Modification   Interest Only Modification   Rate & Term Modification   Rate & Interest Only Modification   Term & Interest Only Modification   Rate, Term & Interest Only Modification   Total 
                                 
Real estate:                                        
Other construction/land  $-   $-   $-   $-   $-   $-   $-   $- 
1-4 family - closed-end   -    13    -    -    -    -    -    13 
Equity lines   -    321    -    29    -    -    -    350 
Commercial real estate - owner occupied   279    123    -    -    -    -    -    402 
Total real estate loans   279    457    -    29    -    -    -    765 
Commercial and industrial   -    133    -    4    -    30    -    167 
Consumer loans   -    9    -    -    -    -    -    9 
   $279   $599   $-   $33   $-   $30   $-   $941 
                                         
                                         
                                         
                                         

 

   For the year ended December 31, 2013 
   Rate Modification   Term Modification   Interest Only Modification   Rate & Term Modification   Rate & Interest Only Modification   Term & Interest Only Modification   Rate, Term & Interest Only Modification   Total 
                                 
Real Estate:                                        
Other construction/land  $-   $416   $-   $-   $-   $-   $-   $416 
1-4 family - closed-end   -    3,338    -    238    -    -    102    3,678 
Equity lines   -    -    40    -    -    -    -    40 
Commercial real estate - owner occupied   -    -    -    557    -    -    -    557 
Total real estate loans   -    3,754    40    795    -    -    102    4,691 
Commercial and industrial   -    1,563    -    308    -    -    -    1,871 
Consumer loans   -    469    -    -    -    -    92    561 
   $-   $5,786   $40   $1,103   $-   $-   $194   $7,123 

 

20
 

 

The following tables present, by class, additional details related to loans classified as TDRs during the referenced periods, including the recorded investment in the loan both before and after modification and balances that were modified during the period:

 

 

Troubled Debt Restructurings                    
(dollars in thousands, unaudited)                    
   For the three months Ended June 30, 2014 
                     
       Pre-Modification   Post-Modification         
   Number of Loans   Outstanding
Recorded
Investment
   Outstanding
Recorded
Investment
   Reserve Difference(1)   Reserve 
                     
Real Estate:                         
Other Construction/Land   -   $-   $-   $-   $- 
1-4 family - closed-end   -    -    -    -    - 
Equity Lines   3    350    350    169    205 
Commercial RE- owner occupied   1    279    279    -    139 
            Total Real Estate Loans        629    629    169    344 
                          
Commercial and Industrial   2    53    53    29    33 
Consumer loans   2    7    7    1    2 
        $689   $689   $199   $379 
                          

 

(1) This represents the change in the ALLL reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowance for loan loss methodology.                  

 

                     
   For the six months Ended June 30, 2014 
                     
       Pre-Modification   Post-Modification         
   Number of Loans   Outstanding
Recorded
Investment
   Outstanding
Recorded
Investment
   Reserve Difference(1)   Reserve 
                     
Real Estate:                         
Other Construction/Land   -   $-   $-   $-   $- 
1-4 family - closed-end   1    13    13    -    - 
Equity Lines   3    350    350    169    203 
Commercial RE- owner occupied   2    402    402    -    141 
            Total Real Estate Loans        765    765    169    344 
                          
Commercial and Industrial   5    167    167    52    43 
Consumer loans   3    9    9    1    2 
        $941   $941   $222   $389 
                          

 

(1) This represents the change in the ALLL reserve for these credits measured as the difference between the specific post-modification impairment reserve and the pre-modification reserve calculated under our general allowancefor loan loss methodology.                                        

 

21
 

 

The tables below summarize TDRs that defaulted during the periods noted, and any charge-offs on those TDRs resulting from such default. 

 

Troubled Debt Restructurings            
(dollars in thousands, unaudited)            
   Subsequent default three months ended June 30, 2014 
   Number of Loans   Recorded Investment   Charge-Offs 
         
Real Estate:               
Other Construction/Land   3   $1,546   $- 
1-4 family - closed-end   2    8,305    - 
Commercial real estate- owner occupied   1    222    31 
            Total Real Estate Loans        10,073    31 
Commercial and Industrial   -    -    - 
Consumer Loans   -    -    - 
        $10,073   $31 
                
                

 

   Subsequent default six months ended June 30, 2014 
             
   Number of Loans   Recorded Investment   Charge-Offs 
Real Estate:               
Other Construction/Land   3   $1,546   $- 
1-4 family - closed-end   2    8,305    - 
Commercial real estate- owner occupied   1    222    31 
            Total Real Estate Loans        10,073    31 
Commercial and Industrial   1    127    - 
Consumer Loans   2    133    58 
        $10,333   $89 

  

Note 12 – Allowance for Loan and Lease Losses

 

The Company’s allowance for loan and lease losses, a contra-asset, is established through a provision for loan and lease losses. The allowance is maintained at a level that is considered adequate to absorb probable losses on certain specifically identified loans, as well as probable incurred losses inherent in the remaining loan portfolio. Specifically identifiable and quantifiable losses are immediately charged off against the allowance; recoveries are generally recorded only when cash payments are received subsequent to the charge off. We employ a systematic methodology, consistent with FASB guidelines on loss contingencies and impaired loans, for determining the appropriate level of the allowance for loan and lease losses and adjusting it at least quarterly. Pursuant to that methodology, impaired loans and leases are individually analyzed and a criticized asset action plan is completed specifying the financial status of the borrower and, if applicable, the characteristics and condition of collateral and any associated liquidation plan. A specific loss allowance is created for each impaired loan, if necessary.

 

22
 

 

The following tables disclose the unpaid principal balance, recorded investment (including accrued interest), average recorded investment, and interest income recognized for impaired loans on our books as of the dates indicated. Balances are shown by loan type, and are further broken out by those that required an allowance and those that did not, with the associated allowance disclosed for those that required such. Included in the valuation allowance for impaired loans shown in the tables below are specific reserves allocated to TDRs, totaling $3.878 million at June 30, 2014 and $3.321 million at December 31, 2013. 

 

Impaired Loans  June 30, 2014 
(dollars in thousands, unaudited)  Unpaid
Principal
Balance(1)
   Recorded
Investment(2)
   Related
Allowance
   Average
Recorded
Investment
   Interest
Income
Recognized(3)
 
                     
                     
With an allowance recorded                         
Real Estate:                         
1-4 family residential construction  $-   $-   $-   $-   $- 
Other construction/land   2,904    2,903    434    3,092    47 
1-4 Family - closed-end   11,055    11,055    1,214    11,918    135 
Equity lines   1,867    1,702    450    1,918    6 
Commercial real estate- owner occupied   2,665    2,555    1,259    2,790    26 
Commercial real estate- non-owner occupied   10,423    10,424    1,079    10,896    148 
Farmland   -    -    -    -    - 
        Total real estate   28,914    28,639    4,436    30,614    362 
Agriculture   -    -    -    -    - 
Commercial and industrial   3,197    3,184    807    3,185    61 
Consumer loans   2,929    2,927    336    3,131    81 
    35,040    34,750    5,579    36,930    504 
With no related allowance recorded                         
Real estate:                         
1-4 family residential construction   -    -    -    -    - 
Other construction/land   2,033    1,975    -    2,409    - 
1-4 family - closed-end   3,637    3,480    -    4,339    - 
Equity lines   746    566    -    759    - 
Commercial real estate- owner occupied   3,483    2,153    -    3,773    - 
Commercial real estate- non-owner occupied   2,669    2,521    -    2,790    58 
Farmland   173    173    -    203    - 
        Total real estate   12,741    10,868    -    14,273    58 
Agriculture   327    327    -    336    - 
Commercial and industrial   93    68    -    123    - 
Consumer loans   401    124    -    528    - 
    13,562    11,387    -    15,260    58 
     Total  $48,602   $46,137   $5,579   $52,190   $562 

  

(1) Contractual principal balance due from customer.

(2) Principal balance on Company's books, less any direct charge offs.

(3) Interest income is recognized on performing balances on a regular accrual basis.          

 

23
 

 

   December 31, 2013 
   Unpaid Principal Balance(1)   Recorded Investment(2)   Related Allowance   Average Recorded Investment   Interest Income Recognized(3) 
                     
                     
With an allowance recorded                         
Real estate:                         
1-4 family residential construction  $-   $-   $-   $-   $- 
Other construction/land   2,972    2,972    502    3,000    98 
1-4 family - closed-end   13,522    13,522    1,324    13,630    260 
Equity lines   528    528    123    530    13 
Commercial real estate- owner occupied   2,047    2,047    217    2,069    135 
Commercial real estate- non-owner occupied   3,715    3,715    701    3,813    238 
Farmland   -    -    -    -    - 
        Total real estate   22,784    22,784    2,867    23,042    744 
Agriculture   125    125    126    131    - 
Commercial and industrial   4,580    4,345    1,925    4,496    131 
Consumer loans   3,411    3,411    431    3,591    172 
    30,900    30,665    5,349    31,260    1,047 
With no related allowance recorded                         
Real estate:                         
1-4 family residential construction   -    -    -    -    - 
Other construction/land   4,176    3,779    -    3,885    - 
1-4 family - closed-end   4,655    4,376    -    4,687    1 
Equity lines   565    493    -    493    - 
Commercial real estate- owner occupied   7,436    5,516    -    5,568    - 
Commercial real estate- non-owner occupied   10,077    9,780    -    9,820    115 
Farmland   282    282    -    290    - 
        Total real estate   27,191    24,226    -    24,743    116 
Agriculture   345    345    -    837    - 
Commercial and industrial   1,249    1,099    -    1,607    57 
Consumer loans   241    52    -    77    - 
    29,026    25,722    -    27,264    173 
     Total  $59,926   $56,387   $5,349   $58,524   $1,220 

 

(1) Contractual principal balance due from customer.

(2) Principal balance on Company's books, less any direct charge offs.

(3) Interest income is recognized on performing balances on a regular accrual basis.                                        

  

The specific loss allowance for an impaired loan generally represents the difference between the face value of the loan and either the fair value of underlying collateral less estimated disposition costs, or the loan’s net present value as determined by a discounted cash flow analysis. The discounted cash flow approach is typically used to measure impairment on loans for which it is anticipated that repayment will be provided from cash flows other than those generated solely by the disposition or operation of underlying collateral. However, historical loss rates may be used to determine a specific loss allowance if they indicate a higher potential reserve need than the discounted cash flow analysis. Any change in impairment attributable to the passage of time is accommodated by adjusting the loss allowance accordingly.

 

For loans where repayment is expected to be provided by the disposition or operation of the underlying collateral, impairment is measured using the fair value of the collateral. If the collateral value, net of the expected costs of disposition where applicable, is less than the loan balance, then a specific loss reserve is established for the shortfall in collateral coverage. If the discounted collateral value is greater than or equal to the loan balance, no specific loss reserve is required. At the time a collateral-dependent loan is designated as nonperforming, a new appraisal is ordered and typically received within 30 to 60 days if a recent appraisal is not already available. We generally use external appraisals to determine the fair value of the underlying collateral for nonperforming real estate loans, although the Company’s licensed staff appraisers may update older appraisals based on current market conditions and property value trends. Until an updated appraisal is received, the Company uses the existing appraisal to determine the amount of the specific loss allowance that may be required, and adjusts the specific loss allowance, as necessary, once a new appraisal is received. Updated appraisals are generally ordered at least annually for collateral-dependent loans that remain impaired. Current appraisals were available for 70% of the Company’s impaired real estate loan balances at June 30, 2014. Furthermore, the Company analyzes collateral-dependent loans on at least a quarterly basis, to determine if any portion of the recorded investment in such loans can be identified as uncollectible and would therefore constitute a confirmed loss. All amounts deemed to be uncollectible are promptly charged off against the Company’s allowance for loan and lease losses, with the loan then carried at the fair value of the collateral, as appraised, less estimated costs of disposition if applicable. Once a charge-off or write-down is recorded, it will not be restored to the loan balance on the Company’s accounting books.

 

 

24
 

 

Our methodology also provides that a “general” allowance be established for probable incurred losses inherent in loans and leases that are not impaired. Unimpaired loan balances are segregated by credit quality, and are then evaluated in pools with common characteristics. At the present time, pools are based on the same segmentation of loan types presented in our regulatory filings. While this methodology utilizes historical loss data and other measurable information, the classification of loans and the establishment of the allowance for loan and lease losses are both to some extent based on management’s judgment and experience. Our methodology incorporates a variety of risk considerations, both quantitative and qualitative, in establishing an allowance for loan and lease losses that management believes is appropriate at each reporting date. Quantitative information includes our historical loss experience, delinquency and charge-off trends, and current collateral values. Qualitative factors include the general economic environment in our markets and, in particular, the condition of the agricultural industry and other key industries in the Central San Joaquin Valley. Lending policies and procedures (including underwriting standards), the experience and abilities of lending staff, the quality of loan review, credit concentrations (by geography, loan type, industry and collateral type), the rate of loan portfolio growth, and changes in legal or regulatory requirements are additional factors that are considered. The total general reserve established for probable incurred losses on unimpaired loans was $6.055 million at June 30, 2014.

 

During the three months ended June 30, 2014, there were no material changes to the methodology used to determine our allowance for loan and lease losses. As we add new products and expand our geographic coverage, and as the economic environment changes, we expect to continue to enhance our methodology to keep pace with the size and complexity of the loan and lease portfolio and respond to pressures created by external forces. We engage outside firms on a regular basis to assess our methodology and perform independent credit reviews of our loan and lease portfolio. In addition, the Company’s external auditors, the FDIC, and the California DBO review the allowance for loan and lease losses as an integral part of their audit and examination processes. Management believes that the current methodology is appropriate given our size and level of complexity.

 

The tables that follow detail the activity in the allowance for loan and lease losses for the periods noted: 

 

Allowance for Credit Losses and Recorded Investment in Financing Receivables
(dollars in thousands, unaudited)                        
   For the Three Months Ended June 30, 2014 
   Real Estate   Agricultural   Commercial and Industrial   Consumer   Unallocated   Total 
                         
Allowance for credit losses:                        
Beginning Balance  $7,396   $847   $1,418   $1,438   $392   $11,491 
          Charge-offs   (307)   -    (226)   (564)   -    (1,097)
          Recoveries   892    1    54    93    -    1,040 
          Provision   (703)   505    270    496    (368)   200 
                               
Ending Balance  $7,278   $1,353   $1,516   $1,463   $24   $11,634 
                               

 

   For the Six Months Ended June 30, 2014 
   Real Estate   Agricultural   Commercial and Industrial   Consumer   Unallocated   Total 
                         
Allowance for credit losses:                              
Beginning Balance  $5,544   $978   $3,787   $1,117   $251   $11,677 
          Charge-offs   (434)   (124)   (412)   (985)   -    (1,955)
          Recoveries   1,199    2    98    263    -    1,562 
          Provision   969    497    (1,957)   1,068    (227)   350 
                               
Ending Balance  $7,278   $1,353   $1,516   $1,463   $24   $11,634 
                               
Reserves:                              
          Specific  $4,436   $-   $807   $336   $-   $5,579 
          General   2,842    1,353    709    1,127   $24    6,055 
                               
Ending Balance  $7,278   $1,353   $1,516   $1,463   $24   $11,634 
                               
Loans evaluated for impairment:                              
          Individually  $39,507   $327   $3,252   $3,051   $-   $46,137 
          Collectively   599,289    25,815    204,253    17,547    -    846,904 
                               
Ending Balance  $638,796   $26,142   $207,505   $20,598   $-   $893,041 

 

 

25
 

 

 

   For the Year Ended December 31, 2013 
   Real Estate   Agricultural   Commercial and Industrial   Consumer   Unallocated   Total 
                         
Allowance for credit losses:                              
Beginning Balance  $8,034   $258   $3,467   $2,114   $-   $13,873 
          Charge-offs   (4,205)   (473)   (1,668)   (1,917)   -    (8,263)
          Recoveries   618    -    802    297    -    1,717 
          Provision   1,097    1,193    1,186    623    251    4,350 
                               
Ending balance  $5,544   $978   $3,787   $1,117   $251   $11,677 
                               
Reserves:                              
          Specific  $2,867   $126   $1,925   $431        $5,349 
          General   2,677    852    1,862    686    251    6,328 
                               
Ending balance  $5,544   $978   $3,787   $1,117   $251   $11,677 
                               
Loans evaluated for impairment:                              
          Individually  $47,010   $470   $5,444   $3,463   $-   $56,387 
          Collectively   530,829    24,710    171,243    20,073    -    746,855 
                               
Ending balance  $577,839   $25,180   $176,687   $23,536   $-   $803,242 

 

Note 13 – Recent Developments

 

On July 17, 2014 the Company entered into a definitive agreement to acquire Santa Clara Valley Bank (OTC: SCVE) of Santa Paula, California, a community bank with approximately $125 million in assets and branches located in Santa Paula, Santa Clarita, and Fillmore, California. The agreement calls for the payment of cash consideration of $12.3 million, or $6.00 per share, to SCVE’s common shareholders and cash consideration of $3.0 million to SCVE’s preferred shareholders to retire outstanding preferred stock and associated warrants. Included in the $12.3 million payment is $700,000 that the Company will pay to cash out existing in-the-money warrants. The transaction, which is subject to customary closing conditions including required regulatory approvals and approval by the shareholders of Santa Clara Valley Bank, is expected to close in the fourth quarter of 2014.

 

26
 

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 Company’s potential future financial performance. They include, but are not limited to, unfavorable 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; reductions in the 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 prospective 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 Note 12 to the consolidated financial statements and the “Provision for Loan and Lease Losses” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; the valuation of impaired loans and foreclosed assets, which is discussed in Note 11 to the consolidated financial statements and in the “Nonperforming Assets” and “Allowance for Loan and Lease Losses” sections of this discussion and analysis; 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; and goodwill, which is evaluated annually for impairment based on the fair value of the Company as discussed in the “Other Assets” section of this discussion and analysis. 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 those areas.

 

27
 

 

 

OVERVIEW OF THE RESULTS OF OPERATIONS

AND FINANCIAL CONDITION

 

results of operations Summary

 

Second Quarter 2014 compared to Second Quarter 2013

 

Net income for the quarter ended June 30, 2014 was $4.237 million, representing an increase of $438,000, or 12%, relative to net income of $3.799 million for the quarter ended June 30, 2013. Basic and diluted earnings per share for the second quarter of 2014 were $0.30, compared to $0.27 for the second quarter of 2013. The Company’s annualized return on average equity was 9.13% and annualized return on average assets was 1.16% for the quarter ended June 30, 2014, compared to 8.62% and 1.09%, respectively, for the quarter ended June 30, 2013. The primary drivers behind the quarter over quarter variance in net income are as follows:

 

·Net interest income increased $675,000, or 5%, due primarily to an $82 million increase in average interest-earning assets and a higher level of non-recurring interest income, partially offset by net interest margin compression.

 

·Gains on securities totaled $183,000 in the second quarter of 2014, relative to no gains in the second quarter of 2013.

 

·Service charges on deposits fell by $176,000 for the comparative quarters.

 

·The loan loss provision was reduced by $250,000, or 56%.

 

·Total non-interest expense increased $291,000, or 3%, primarily due to costs associated with our new core banking software that was implemented in February 2014.

 

First Half 2014 compared to First Half 2013

 

Net income for the first half of 2014 was $8.036 million, representing an increase of $1.904 million, or 31%, relative to net income of $6.132 million for the first half of 2013. Basic and diluted earnings per share for the first half of 2014 were $0.57 and $0.56, respectively, compared to $0.43 basic and diluted earnings per share for the first half of 2013. The Company’s annualized return on average equity was 8.75% and annualized return on average assets was 1.12% for the six months ended June 30, 2014, compared to a return on equity of 7.03% and return on assets of 0.89% for the six months ended June 30, 2013. The primary drivers behind the variance in year-to-date net income are as follows:

 

·The single largest impact on the comparative year-to-date results came from a reduction of $1.700 million, or 83%, in the loan loss provision.

 

·Net interest income increased $1.048 million, or 4%, due to a $58 million increase in average interest-earning assets and a higher level of non-recurring interest income.

 

·Total non-interest income declined by $413,000, or 5%, in the first half of 2014 due to a drop in service charges on deposits, lower BOLI income, and a $100,000 non-recurring signing incentive received in conjunction with our conversion of merchant processing to a new vendor in the first quarter of 2013, partially offset by an increase in gains realized on the sale of investment securities.

 

·Total non-interest expense fell by $802,000, or 4%, as higher marketing, data processing, and deposit costs were more than offset by a reduction of $1.178 million in net costs associated with foreclosed assets.

 

·The Company’s provision for income taxes was 26% of pre-tax income for the first half of 2014, relative to 20% for the first half of 2013.

 

28
 

 

Financial Condition Summary

 

June 30, 2014 relative to December 31, 2013

 

The most significant characteristics of, and changes in, the Company’s balance sheet during the first six months of 2014 are outlined below:

 

·The Company’s assets totaled $1.498 billion at June 30, 2014, an increase of $88 million, or 6%, relative to total assets of $1.410 billion at December 31, 2013 due to growth in loans and investments net of reductions in foreclosed assets and balances due from banks.

 

·Gross loans increased by $90 million, or 11%, due to growth in mortgage warehouse loans, commercial real estate loans and real estate loans secured by farmland, in addition to the purchase of $33 million in residential mortgage loans in the first quarter of 2014.

 

·Total nonperforming assets, comprised of nonperforming loans and foreclosed assets, were reduced by $12 million, or 26%, to $34 million at June 30, 2014 from $46 million at December 31, 2013.

 

·Investment securities increased $35 million, or 8%, during the first half of 2014 but interest bearing balances held in our Federal Reserve Bank account were reduced by $23 million, or 85%, pursuant to our purchase of mortgage-backed securities as we deployed excess liquidity.

 

·Total deposits reflect growth of $72 million, or 6%, during the six months ended June 30, 2014. Core non-maturity deposits were up $80 million, or 9%, although some of that increase appears to be seasonal.

 

·Total capital increased by $5 million, or 3%, to $187 million at June 30, 2014, due primarily to an increase in retained earnings net of the impact of the Company’s repurchase of 270,100 shares in the first half of 2014. While still robust, our consolidated total risk-based capital ratio declined to 20.10% at June 30, 2014 from 21.67% at year-end 2013 due to growth in risk-adjusted assets. Our tier one risk-based capital ratio was 18.94% and our tier one leverage ratio was 13.87% at June 30, 2014.

 

 

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 expense is comprised of operating costs that relate to providing a full range of banking services to our customers.

 

Net interest income AND NET INTEREST MARGIN

 

In a reversal of recent adverse trends, net interest income increased by $675,000, or 5%, for the second quarter of 2014 relative to the second quarter of 2013, and by $1.048 million, or 4%, for the first half of 2014 compared to the first half of 2013. The level of net interest income recognized in any given period depends on a combination of factors including the average volume and yield for interest-earning assets, the average volume and cost of interest-bearing liabilities, and the mix of products which comprise the Company’s earning assets, deposits, and other interest-bearing liabilities. Net interest income is also impacted by the reversal of interest for loans placed on non-accrual status during the reporting period, and the recovery of interest on loans that had been on non-accrual and were paid off, sold or returned to accrual status.

 

29
 

 

The following tables show average balances for significant balance sheet categories, and the amount of interest income or interest expense associated with each applicable category for the noted periods. The tables also display the calculated yields on each major component of the Company’s investment and loan portfolios, the average rates paid on each key segment of the Company’s interest-bearing liabilities, and our net interest margin for the noted periods.

 

Average Balances and Rates  For the three months ended   For the three months ended 
(dollars in thousands, except per share data)  Ended June 30, 2014   Ended June 30, 2013 
   Average   Income/   Average
Rate/
   Average   Income/   Average
Rate/
 
Assets   Balance (1)    Expense    Yield (2)(3)    Balance (1)    Expense    Yield (2)(3) 
Investments:                              
Federal funds sold/due from time  $20,561   $16    0.31%  $26,115   $16    0.24%
Taxable   356,280    1,876    2.08%   314,191    1,034    1.30%
Non-taxable   97,233    733    4.52%   86,626    672    4.65%
Equity   2,542    -    -    2,144    -    - 
Total investments   476,616    2,625    2.49%   429,076    1,722    1.91%
Loans and Leases:(4)                              
Real estate   629,352    8,340    5.32%   559,098    7,848    5.63%
Agricultural   23,667    227    3.85%   24,219    247    4.09%
Commercial™   96,900    1,102    4.56%   96,893    1,249    5.17%
Consumer   21,643    477    8.84%   25,744    540    8.41%
Mortgage Warehouse Lines   84,305    868    4.13%   114,736    1,440    5.03%
Direct financing leases   2,402    32    5.34%   3,133    44    5.63%
Other   303    11    14.56%   8    -    - 
Total loans and leases   858,572    11,057    5.17%   823,831    11,368    5.53%
Total interest earning assets (5)   1,335,188    13,682    4.22%   1,252,907    13,090    4.30%
Other earning assets   6,072              6,168           
Non-earning assets   129,437              139,815           
Total assets  $1,470,697             $1,398,890           
                               
Liabilities and shareholders' equity                              
Interest bearing deposits:                              
Demand deposits  112,800   $72    0.26%  $87,828   $77    0.35%
NOW   247,667    86    0.14%   194,194    95    0.20%
Savings accounts   151,938    75    0.20%   131,341    71    0.22%
Money market   73,337    21